Fixed Index Annuity 1035 Exchange Guide
The Internal Revenue Service (IRS) allows you to exchange an annuity policy that you own for a new annuity policy without paying tax on the investment gains earned on the original contract.
This can be a substantial benefit.
This rule is governed by Section 1035 of the Internal Revenue Code which is why these are called “1035 Exchanges.” Below is a direct link to the complete text of the code.
1035 Exchange Rules
There are a couple of important rules that must be followed in order to receive the benefits of a 1035 Exchange.
- The tax code says that the old annuity policy must be exchanged for a new policy – you cannot receive a check and apply the proceeds to the purchase of a new insurance policy.
- You can 1035 exchange from a life insurance policy to an annuity
- You can 1035 exchange from an annuity to a long-term care policy under the Pension Protection Act of 2006
- You can not 1035 exchange from an annuity to a life insurance policy
Here is an example of an actual 1035 Exchange form you would need to complete to move from one annuity to another via a 1035 Exchange.
Fixed Index Annuity Taxation
The deciding factor on how your annuity will ultimately be taxed depends ultimately on the money you used to buy it. Whenever a client asks us how are annuities taxed, our first response is where did you get the money to buy it?
Since we are talking about taxes there is no way to say with certainty exactly how your annuity will be taxed. Tax laws and tax rates can and do change all the time.
However, we can make very educated guesses about certain scenarios based on how annuities have been and are taxed currently. First, we will look at the types of funds you can use to purchase an annuity and explain the differences in how they are taxed.
Roth IRA Taxation
If you purchase an annuity with funds from a Roth individual retirement account (IRA) or Roth 401(k) it is very likely you won’t have to pay federal income tax at all on the money when you withdraw it from your annuity. That includes the principal and interest.
How Are Qualified Annuities Taxed?
An annuity purchased with qualified funds is considered a qualified annuity. Qualified funds are monies that you have never paid taxes on such as a traditional IRA or a traditional 401(k). It would be nice if the IRS would allow going from tax-deferred to tax-free but that is not the case.
When you begin to make withdraws from a qualified annuity you will pay normal federal income taxes. Meaning, that 100% of your annuity is treated as ordinary income and 100% of the funds will be taxed when they are taken.
Non-Qualified Annuity Taxation
A non-qualified annuity is an annuity purchased with after tax-dollars such as money from a taxable personal savings or checking account or a personal brokerage account.
If you own a non-qualified annuity, you will only pay income tax on the gain in your contract but not the money you used to purchase the annuity. The money used to purchase a non-qualified annuity is considered the “basis”. Insurance companies keep track of your “cost basis” which is the original amount used to purchase an investment.
This “cost-basis” is the amount of money on which you will not pay taxes because you’ve already taxes on it once.
Fixed Index Annuity Buyers Guide
Available Indexes: The stock market indexes are available in the index annuity. We have a list of available stock market indexes available at each insurance carrier for simplicity.
Duration: Typically the longer contract you purchase the higher your guaranteed interest rate will be. But that is not the case, especially given the current inverted yield curve.
Liquidity: Most all fixed annuities have some type of annual free withdrawals, but the amount available varies by product. You’ll see most of the fixed annuities at our marketplace provide interest-only withdrawals annually. Others allow for 10% Free Withdrawals (10% of the previous year’s account value) annually.
Insurance Company’s Financial Rating: It is very important to consider an insurance company’s financial rating because it is an indicator of its ability to fulfill financial commitments to its policyholders. Usually, a lesser-rated insurance company will offer higher fixed annuity rates, but that is not always the case.
Pros and Cons of Indexed Annuities
Fixed Index Annuity Advantages
#1 Gain Compounded Earnings While Deferring Income Taxes
#2. Earn Higher Interest Rates
#3. Make Contributions to Your Tax-Deferred Account
#4. Protect Your Principal from Downturns in the Credit Markets
#5. Retire Early Without Penalty
#6. Satisfy Required Minimum Distributions (RMDs)
#7. Retire with Lifetime Income
#8. Lifetime Income More Flexible Than Annuitization
Disadvantages of a Fixed Index Annuity
#1. Pre 591/2 10% IRS penalty.
#2. Highly Customizable / Complicated
#3. The surrender Charge applies to early withdrawals during the surrender charge period.
#4. Won’t generate returns as high as an equity investment.
In our Fixed Index Annuity Pros and Cons we compare and contrast the advantages and disadvantages of an indexed annuity in greater detail.