The process of using funds from an existing annuity to purchase another annuity is commonly referred to as an annuity exchange. If the funds being used are non-qualified (i.e. not held in something like an IRA), then the exchange would be a 1035 exchange (so named for Section 1035 of the IRS Code, which governs such exchanges). If the funds being used are qualified, then the annuity exchange is governed by the rules governing the IRA or other qualified plan within which the annuity is held.
Exchanges involving life insurance are also classified as 1035s. A life insurance policy can be exchanged for an annuity under the rules of a 1035 exchange, but you cannot exchange an annuity contract for a life insurance policy. I’ll focus on an annuity-to-annuity exchange in this article.
A 1035 exchange is a way to exchange an existing annuity for another annuity that either achieves a different goal or provides a better rate, all while maintaining the tax-deferred status of your annuity. For non-qualified annuity owners who are unhappy with their current contract or are looking for something new, understanding the 1035 exchange process is the best place to start.
Although not all annuity contracts can be exchanged, the majority of annuities in the market do allow for full or partial exchanges. Irrevocable annuities without cash values – think income annuities, like longevity and immediate annuities – cannot be exchanged. All other annuities that provide some liquidity or have a surrender schedule – think fixed, indexed, and variable annuities – can be exchanged.
When deciding if a 1035 exchange makes sense for you, it’s important to take into account why you purchased the original annuity and why it is no longer meeting your goals. Orienting your thoughts around your reason for originally purchasing the annuity you own, whether it was guaranteed growth, a bequest motive, tax deferral, or access to market upside, and comparing that goal to your current objective can help to determine if your annuity is still meeting your needs or if you should consider new annuity options.
Whether you’ve already decided to do or are just beginning think about doing a 1035 exchange, there are seven factors to keep in mind.
1. Always check the rate with your current insurer. If your annuity provides a guaranteed interest rate, you’ll want to confirm with the insurer what that rate is currently and under what circumstances it could change in the future. You’ll want to do this to ensure that you’re getting a better deal by exchanging for a new annuity, which is both required by regulations and in your financial interest.
2. Know your surrender schedule (if any). Most fixed annuities have a surrender schedule that’s equal in duration to the investment term of the contract, and most fixed indexed annuities have surrender schedules that can last anywhere from 7-15 years. If you exchange an annuity while it’s still in the surrender period, you’ll have to pay a penalty (often a hefty one), so it’s important to confirm your surrender schedule with the insurer prior to making any decisions. The surrender charge is typically highest in year 1 and will decrease over the term. There can be instances where it makes sense to exchange an annuity before it’s out of its surrender period, but in most cases you’ll be better off waiting for the end of the surrender period so that you do not pay a fee. If you’re thinking of doing a 1035 exchange during the surrender period, you must be able to prove to the new insurer that you can receive a better interest rate or a higher income rate even after taking the penalty into account.
3. Know how much time you have to do the exchange penalty-free. In general, fixed annuities have at least a 30 day window at the end of the surrender period when you can execute a 1035 exchange penalty-free before there is a renewal to a new rate. For other products, like variable annuities, there’s no concept of “renewal” so there is more flexibility around when you’re able to do an exchange. Focusing in on fixed annuities, the 30 day window in the contract is the key piece of information you’ll want to keep in mind to ensure you allocate sufficient time to complete the exchange. Most insurers will send you a letter as the end of your guarantee term approaches specifying what happens at the end of the term. In general, insurers will either provide you with a 30 day window before or after the end of the term where you can make your exchange. The 1035 exchange process can take anywhere from 1-3 weeks, so it’s always best to make sure you’re aware of the 30 day window and your options so that you’re ready to act towards the beginning of the window in order to ensure it is completed by the end of the window.
4. Know what happens if you do nothing at the end of the guarantee term. If your fixed annuity reaches the end of the term and you have not told the insurance company what you’d like to do with the funds in the annuity, one of these three things will likely occur.
- Your fixed annuity will automatically renew into a new guarantee period of the same term with the rate effective at that time.
- Your fixed annuity will automatically renew into a 1-year guarantee period with the rate effective at that time.
- Your fixed annuity will not renew for a new guarantee period but the funds left in the contract will earn a new (and likely lower) interest rate effective at that time.
It’s important to understand which option your annuity defaults to if you do not make an election at the end of the initial guarantee period. If you think you’re likely to forget about the term end date of your annuity or will have trouble executing a 1035 exchange within the allocated window, it’s best to search for products that do not automatically renew for a new guarantee period of the same term. In general, as long as you’re diligent about the term end date, you should be able to complete a 1035 exchange within the allotted time period so that your annuity does not renew for another term.
5. Know the most important policy details. If you decide to begin the 1035 exchange process, you’ll need to be able to provide the new insurer with details of your existing annuity so that they’ll be able to determine an exchange is in your best interest and so that they’ll be able to request funds from the old annuity. Here’s a list of the policy information that’s required for most exchanges:
- The insurer name
- Product type (fixed annuity, variable annuity, indexed annuity)
- Contract/policy number
- Type of funds used to purchase the product, such as qualified (pre-tax funds such as Traditional IRA) or non-qualified (post tax funds such as checking/savings accounts)
- Initial premium (i.e. cost basis)
- Purchase date
- Owner and joint owner
- Cash value
- Surrender charge (if any)
- Death benefit
- Reason for exchange
While this list may seem daunting, the majority of this information can be found in your policy documents. You’ll want to look for a page that’s titled Contract Summary or Contract Details. If you no longer have a copy of your contract, you can always reach out to the insurer who issued your policy or the agent who sold you the policy.
6. If you’re not happy with your existing insurance agent, there are options. Similar to how when you exchange an annuity you are not required to stay with the same insurance company, you also don’t need to work with the same insurance agent when doing a 1035 exchange. Whether you’ve had an unpleasant experience with your annuity agent, your agent doesn’t have a product you’re interested in, or if your agent has retired, a 1035 exchange is a great way to start over and build a new relationship with another agent or agency. Consulting other agents or online annuity marketplaces prior to doing a 1035 exchange is a great way to make sure you’re seeing the entire market of available options and to make sure that your agent is getting you the best deal possible.
7. Know the primary goal of the product you’re purchasing. No matter what type of annuity you have, you can exchange it for any other type as long as the product you’re exchanging from offers liquidity. It’s best to start by defining your goals and then finding a product that gets you closest to achieving these goals.
- If you want guaranteed income, consider exchanging your existing contract for an immediate annuity or a longevity annuity. You’ll want to compare it to the guaranteed income you’d receive from an income rider with your existing product (if you have one) or your existing product’s annuitization amount.
- If you want guaranteed growth, consider exchanging to a fixed annuity. You’ll want to ensure you are getting a higher guaranteed interest rate than your existing policy provides.
- If you want potential for market upside you should consider exchanging to a fixed indexed annuity or variable annuity. You should compare the fees, cap, participation rates, guaranteed interest rates, and riders on the new contract to your existing policy.
If you have an annuity that’s nearing the end of the guarantee term or you’re thinking about your first annuity purchase, this list can be used as a guide to make sure you’re aware of what to consider prior to purchase and are prepared to decide what to do with your annuity later on. Keeping track of important dates and staying current on annuity rates/product availability will help you make the best decision for your annuity purchase.
Note: This is not tax or investment advice.