1035 annuity transfers


1035transfers

If you hold a high-cost deferred variable annuity contract or own an unneeded cash value life insurance contract you can transfer the  annuity or cash value to a low-cost  no-load annuity by means of a  tax-free 1035 transfer.

A variable annuity is an insurance investment product that offers investors stock, bond, money market, and balanced portfolios within a tax-deferred insurance wrapper.

Contents

Annuity costs

A sensible reason to transfer a deferred annuity contract is to reduce the cost of investing.  Both the SEC  and FINRA  have issued warnings highlighting  transfer risks arising from commissioned sales motivated transfers (these include the potential imposition of higher costs, and the potential loss of insurance benefits).

The typical U.S. variable annuity contract is encumbered with  high investment management and insurance costs. According to Morningstar the average variable annuity cost   2.27% in 2013.

In addition to this expense ratio cost, many variable annuities also level surrender fees on investors wishing to cash out or transfer their contracts.  These surrender fees usually average between six to eight years but some contracts can impose even longer surrender terms. The surrender fee is set as a percentage fee of the redemption amount. Usually the fee is reduced over the surrender term.  A typical pattern for an annuity with a six year surrender term is displayed in the table below.

Surrender in year Surrender fee
1 6%
2 5%
3 4%
4 3%
5 2%
6 1%
7 0%

When the variable annuity is held in a taxable account withdrawals are subject to income tax at marginal tax rates and for certain taxpayers  the 3.8% Medicare tax on investment income.  As with other tax-deferred schemes, the federal government imposes an additional 10% penalty tax on withdrawals made prior to age 59½.  For annuities  purchased after August 13, 1982, withdrawals are taxed on a last in, first out (LIFO) basis, so earnings are taxed first. Once earnings have been withdrawn any withdrawn basis is nontaxable.

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Transferring annuity contracts

When a variable annuity is held within a tax-deferred plan it is known as a qualified annuity.  An annuity held outside of a tax-deferred account  is known as a non-qualified annuity.

Qualified annuity plan transfers

Your employer provided retirement plan may be  funded with a deferred variable annuity.  This is very frequent with 403-b plans and less frequent with 401-k plans.

If you are considering transferring the plan’s annuity assets to a traditional IRA (a common action after you leave your employer) it is important to realize that the transfer does not have to be to another annuity.  You can transfer the qualified account to an IRA mutual fund account or an IRA brokerage account.

Non-qualified annuity plan transfers

For variable annuities held in taxable accounts,  the only means of transferring a contract without incurring a taxable distribution on any gains  is to use a 1035 exchange.

In order to qualify for tax-free exchanges of annuity balances the IRS requires that:

  • The contract  exchange  must take place directly between the insurance companies. You cannot receive a check and apply the proceeds to the purchase of a new annuity contract.
  • The owner, insured and annuitant must be the same on the new contract as listed on the old contract.

Investors considering an exchange of a deferred variable annuity held in a taxable account will find the following conditions to be optimal for making a transfer of contracts:

  • When the new annuity contract has lower insurance fees and portfolio expense costs, and a suitable range of asset class choices.
  • When the new contract does not impose surrender fees.
  • When the investor does not face high surrender fees by exchanging the existing contract.
  • If your annuity has a significant gain,  a 1035 exchange to a lower cost contract will continue the tax deferral on the gain.

Companies offering no-load variable annuity contracts include Fidelity,  T. Rowe Price,  Charles Schwab, TIAA-CREF and Vanguard.

Annuitycostdifferential

Assumed 7% investment return reduced by 2.27% average annuity cost vs. 0.49% low cost annuity. $50,000 initial investment

As is  usually the case,  the Vanguard deferred variable annuity is among the lowest cost offerings.

A Vanguard  balanced index portfolio can be held at a total expense cost of 0.49% (although the annuity imposes an annual $25 account maintenance fee for contracts holding less than $25,000).

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Variable annuity losses

While many long-term holders of non-qualifed tax-deferred variable annuities will have investment gains when considering a 1035 exchange, there are times when a contract holder will be holding a contract that can be exchanged or liquidated at a loss.  The 2000 – 2002 bear market in stocks and the 2008 financial crisis are two recent episodes where investors experienced dramatic stock market declines.

A variable annuity investor has three options when holding a loss in a high-cost contract:

  • Continue to hold the contract
  • Liquidate the contract
  • A 1035 exchange to a lower-cost contract

Holding the contract

If you face a high surrender charge for liquidating or transferring your variable annuity contract you may decide to hold the contract until the surrender fee is lower.

IRS tax rules do not allow a taxpayer to add the surrender fee to the cost basis of the contract so it does not increase the taxable loss.

A second consideration for holding a variable annuity with a loss is that the most prevalent and basic annuity insurance feature, the death benefit, can possess a positive value, which would be lost if one liquidates or transfers the contract.

For example, suppose you purchased a variable annuity with a series of payments totaling $100,000.  During a market drop, the value of the annuity sinks to $60,000.   In this instance, under the most basic death benefit, your beneficiaries would receive the greater of present value or premium payments. Thus the death benefit would possess a $40,000 insurance benefit.  Note that some contracts may offer (for an increased annual fee) an enhanced death benefit that insures  a contract’s appreciation value.  Thus if our annuity had increased in value to $120,000 before the fall in value, this appreciated value would be insured by the death benefit.

You would have to decide if the death benefit (which only goes to your beneficiaries after your death)  is of sufficient value to you to warrant holding the annuity.

Liquidating the contract

If you hold a non-qualified variable annuity with a loss, you might consider liquidating the contract for its present value.  Because there is no gain you will not incur an income tax on the distribution, nor will you be accessed a 10% early withdrawal penalty tax.  You can report the loss on your tax return.

There is no clear guidance from the IRS on now variable annuity losses are to be taken on the tax return.  Accountants choose between two methods, a conservative method and an aggressive method.

  • Conservative approach: The conservative approach to taking  the loss is to report it as an itemized deduction on the 1040 Schedule A.  The loss is taken as a miscellaneous deduction. You can claim the amount of loss that is more than 2% of your adjusted gross income.  In addition, miscellaneous deductions are disallowed if you are subject to the alternative minimum tax.
  • Aggressive approach: Some accountants use a more aggressive approach to reporting variable annuity losses by filing the loss under the “other profits and losses”  line 14 on the 1040 tax form.   This loss  is not subject to the 2% miscellaneous deduction limit,  nor is it subject to the alternative minimum tax.  However, using this aggressive approach may result in  the IRS  flagging the return for a closer examination, and there’s no clear authority that the loss belongs on this line.
A 1035 exchange to a lower-cost contract

You may opt to transfer a high-cost variable annuity with a loss to a low-cost, no-load, no surrender fee variable annuity.  In this instance the basis of the old contract remains intact (although, if selected as an option, any death benefit with the new contract will only insure the present value of the contract).

You can thus  have a tax-free accumulation of value up to your basis in the contract. Liquidating the contract at this point will result in no gain and no tax.

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About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

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October 2014
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