While fixed lifetime annuities can be a helpful part of a portfolio (during retirement), variable annuities are usually quite the opposite. More often than not, they’re loaded with very high fees and are only purchased as a result of a slick sales presentation.
Unfortunately, once you’ve purchased a variable annuity, it can be quite costly to get your money out of it. The insurance company will often require you to pay a surrender charge. And, if the variable annuity was a deferred variable annuity, there will be tax costs as well:
- Distributions prior to age 59.5 would be subject to a 10% penalty (unless you’re disabled or you have started taking distributions in the form of a “series of substantially equal periodic payments” designed to distribute the entire balance over the course of your life expectancy), and
- The gains would be taxed as ordinary income.
Note #1: These tax costs only apply if the annuity is in a taxable account. If the annuity is in a tax-sheltered account (such as a 401(k) or IRA), you can sell it and move to a different investment within that tax-sheltered account.
Note #2: If the annuity is in a taxable account, but it currently has an unrealized loss (rather than a gain) it might actually be beneficial to liquidate it rather than do the 1035 exchange described below, due to the fact that the tax only applies to gains, not to the entire amount of the annuity.
Tax-Free 1035 Exchange
Fortunately, there’s a way to get around the tax costs. Section 1035 of the Internal Revenue Code allows you to make an exchange from one annuity contract to another, without paying any taxes as a result of the transaction — thereby allowing you to switch to an annuity from a low-cost provider like Vanguard or Fidelity.
Potentially important point: Section 1035 also allows for the tax-free exchange of an annuity to a long-term care insurance contract, which in some cases may be more beneficial.
It’s analogous to rolling a 401(k) into an IRA: The money goes from one place to another, but (when done properly) it’s not a taxable transaction.
Should You Do a 1035 Exchange?
The fact that you can make an exchange without paying taxes doesn’t necessarily mean it’s a good idea.
To see whether or not an exchange makes sense, you’ll first want to find out how much you’d be saving per year (in the form of reduced expenses) if you did make the switch. Against that, you’ll want to compare:
- Any applicable surrender fee, and
- The value of any insurance benefit you’d be giving up (if, for example, the policy has a death benefit that’s far higher than the annuity’s current market value).
With that information, you can see how many years it would take before the annual savings from switching would surpass the one-time costs you’d have to pay to switch.
How to Do a 1035 Exchange
The most important thing to know about executing a 1035 exchange is this: Do not liquidate your existing annuity with the intent of using the money to buy another. That would not be a tax-free exchange. That would be a taxable transaction.
Instead, the exchange must occur directly between the two insurance companies.
To get the process started, just call the annuity provider you’re planning to switch to and give them your information. They’ll pre-fill the necessary paperwork and send it to you for your signature.
Once you send that back in, the transfer will take place entirely between the two annuity providers.
As far as tax reporting goes, you shouldn’t have to do anything. You’ll receive a Form 1099-R that reports the distribution as a tax-free 1035 exchange, but you don’t have to do anything with that form other than keep it for your records.
Hi. I'm Mike Piper, the author of this blog. I'm 
Good post Mike, I’ve used 1035 exchanges over the years to move clients with existing variable annuiites into lower cost vehicles with much success.
Mike,
I was a “victim” of a slick sales pitch that got me into a variable annuity. I recently bit the bullet and paid the surrender charge to get out. Since this annuity was within an IRA account, there was no penalty from IRS for liquidating it with the proceeds staying in the IRA. This may be an “out” for others as well.
What clinched the decision for me was that I reached the anniversary where I could start taking my “guaranteed income for life” and looked close enough to see what a “deal” I had. I was shocked (shocked!) to learn that what I was taking out was from the principle! They charged me $220 yearly fee to allow me to get at $2500 of my own money! Turns out that even if I didn’t bail out, that yearly fee would add up to the surrender charge in just a few years anyway. Essentially I would pay the equivalent of the surrender charge every few years even if I DIDN’T take the money and run. And given its current value I had a LONG way to go to recover from 2008-2009 before I grew it past the high watermark where I would start to increase the monthly payout. Especially if I took that $2500 every year.
I did the math and bailed.
I realize there is more to an annuity and that it would continue to pay even when the principle was exhausted but my analysis showed that I only needed a 4% return to allow me to then take out the same dollar value “forever” starting in 12 -13 years. If I took less out I would even have a reasonable expectation of it growing. Also, the value would be part of my estate instead of vaporizing.
Bob, thank you for pointing out that I forgot to mention that the tax consequences only apply in a taxable account! I’ve updated the article.
From my (admittedly limited) experience looking at various variable annuities, it appears that your situation is fairly typical — the annual fees often add up to the surrender charge in just a few years, in which case it likely makes sense to bite the bullet and get out ASAP.
You can use 1035 to do a bunch of different things:
WL to WL if same insured
Endowment Contract to a Deferred Annuity
Deferred Annuity (fixed or variable) to a SPIA
Multiple Annuity Contracts to a Single Annuity
The tradeoff between the surrender charge and the higher expenses needs some more attention. You only said one should compare the savings off expenses against the surrender charge, but how? If the variable annuity has a 1% higher expense ratio but a 5% surrender charge which goes away in five years, should you 1035 exchange now or wait out the surrender period? Or is it almost always good to pay the surrender fee now, with the way they set up the surrender fee schedule?