With the near disappearance of the defined benefit pension plan, more retirees are having to find alternate ways to generate an ongoing, reliable income stream that lasts as long as they need it to. One strategy for accomplishing this is through an annuity.

If you purchased an annuity in the past, though, either for its income generation or tax-deferred growth – or both – it is possible that it no longer fits your current and potential future financial needs.

In this case, you may want to consider a 1035 exchange, which allows you to essentially “trade in” your present annuity for another one that is more beneficial for you. But before you move forward with any type of annuity exchange transaction, it is important to understand how the process works, as well as both the potential pros and cons of exchanging an annuity.

Options for Obtaining an Annuity that is a Better Fit for Your Goals

If or when the time comes to do away with a current annuity, you actually have a couple of options. One is to simply cancel it. This, however, could be costly – especially if it is still within its surrender period.

This is a time period – usually several years – where you will incur an early withdrawal charge for taking money out of the annuity contract. (In many cases, you can access up to 10% of the contract value penalty-free, but will be charged on the remainder).

The amount of the surrender charge is stated as a percentage of the withdrawal amount. Such as 9% or 10% – and typically the percentage decreases over time, until the surrender charge eventually disappears.

Example of an Annuity Surrender Charge Schedule

StrategyEligible for the Current Tax Year
(Yes or No)
Itemize or use the IRS standard deductionYes / No
Qualified Charitable Distribution (QCD)Yes / No
Maximize traditional retirement plan and/or IRA annual maximum contributionsYes / No
Fund a small business retirement plan (if applicable)Yes / No
Shorten the Roth IRA 5-year penalty-free withdrawal ruleYes / No
Access any flexible spending account (FSA) funds that won’t be carried over to avoid and IRS penaltyYes / No
Take any necessary Required Minimum Distributions (RMDs) to avoid an IRS penaltyYes / No
Take any 72(t) withdrawals that are due to avoid an IRS penaltyYes / No
Explore Net Unrealized Appreciation (NUA) opportunities to lower the tax on the gain(s)Yes / No

In addition, you could also owe tax on any of the gain that you withdraw. So, depending on your tax bracket – and if you are hit with a surrender charge – it is possible that you may only net half of what you had in the annuity.

The alternative option is to do a 1035 exchange. A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, as well as for certain life insurance policies, long-term care insurance, and endowment policies, in exchange for another one that is of “like kind.”

One of the biggest benefits to conducting a 1035 exchange is that it allows an annuity owner to “trade” one product for another, without incurring any tax consequences. Therefore, if an annuity that you own is not performing the way that you hoped it would, or if your needs have changed and another annuity could serve you better, then this type of transaction could be a viable option for you.

Before You Exchange an Annuity, You Need to Know This…

Even if a 1035 annuity exchange appears to be a good move for you, there are some important items that you need to keep in mind, such as:

  • Making a direct transfer from one annuity to another (versus cashing out of the old annuity and then using the cash to purchase the new one).
  • Possible taxes incurred if the new annuity is not offered by the same insurance carrier that the old/current annuity was.
  • Fulfilling the obligations of the original annuity contract (in this case, it may still be possible to incur a surrender charge, however, if you exchange annuities that are from the same insurer, this fee may be waived).

Are You Ready to Exchange Your Current Annuity for One that is a Better Fit?

If you’re ready to move forward with a 1035 annuity exchange, it is recommended that you work with an annuity specialist who can guide you through the process. At Annuity Gator, our main focus is on helping people determine which annuity – if any – may fit their needs.

So, if you would like to talk with an expert, feel free to contact us directly by phone at (888) 440-2468 or via email by going to our secure online contact form. We look forward to assisting you.

How to exchange your current annuity tax-free for one that is a better fit