Can Clients 1035 an Inherited Annuity?

Annuity products are one area in which trends in contract features are constantly changing as insurance companies endeavor to more effectively meet the needs of annuity investors and with the attendant problem that beneficiaries of inherited annuities could end up with antiquated investment products.

This constant evolution of investment trends may have your clients wondering what type of value their annuities will offer beneficiaries after their death. The IRS has just blessed a solution to this planning dilemma by allowing a beneficiary to exchange inherited annuities for another annuity product that more accurately reflects the beneficiary’s investment goals. A careful reading of this decision releases the annuity beneficiary from the investment choices made by the previous generation and allows them to buy a more appropriate annuity on a tax-free basis.

Tax-Free Exchange of Annuities Before PLR 201330016

In general, the original owner of a nonqualified annuity product is able to exchange one annuity for another in an IRC Section 1035 exchange without treating the transaction as a sale—no gain is recognized when the first annuity contract is disposed of, and there is no intervening tax liability. Despite this, Section 1035 requires that, for the annuity exchange to be tax-free, the newly acquired annuity must be payable to the same individual that was entitled to annuity payouts under the original annuity.

Further, the rules governing the distribution of annuity amounts after the original account owner’s death prevented the beneficiaries of inherited annuities from taking advantage of this tax-free exchange treatment. Under the IRC, a beneficiary of an inherited annuity is required to receive the entire interest under the annuity contract either within five years of the original owner’s death or as an annuity stream based on the beneficiary's own life expectancy. If the beneficiary chooses to take a lump sum distribution, the amount of the distribution that exceeds the original owner’s investment in the contract is taxable income to the beneficiary.

Tax-Free Exchange of Annuities After PLR 201330016

In a private letter ruling released July 26, 2013—PLR 201330016—the IRS examined the currently applicable IRC provisions and their legislative history, finding that the beneficiary who inherits rights to payouts under an annuity also inherits an ownership interest in the annuity that is sufficient to allow tax-free exchange treatment under IRC Section 1035.

In this case, the beneficiary inherited multiple annuity products and elected to receive distributions over her life expectancy after the death of the account owner (her mother). Later, she found an annuity product that offered more attractive investment features and sought to exchange the original contracts for an annuity that would increase her annuity payout but would continue to distribute those payouts over her life expectancy.

By allowing this exchange, the IRS permitted the beneficiary to exchange the entire pre-tax value of the inherited annuity, rather than requiring that she take a lump sum distribution of the inherited annuity interest, pay taxes on this distribution and then purchase the replacement annuity contract with the after-tax value.

However, the IRS was careful to note that the rules applicable to post-death distributions still apply, meaning that the newly acquired annuity must require distribution of the entire interest in the inherited annuity within five years or over the beneficiary’s life expectancy.

Conclusion

Though this IRS ruling can technically only be relied upon by the parties to which it was addressed, it indicates an expansion of the rules governing Section 1035 exchanges so that as long as the annuity interest is distributed properly and all other IRC requirements are satisfied, the owners of inherited annuities will have the freedom to exchange these products in order to more effectively meet their personal investment goals.

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