Today’s marketplace is crowded with annuity products—and in many cases, clients who are locked into variable annuities may find themselves evaluating the possibility of exchanging the product for something new. Unfortunately, though an exchange is typically a tax-free transaction, significant hidden risks exist that can make an exchange unattractive. Informed professional guidance is therefore crucial to navigating the decision making process—to ensure both that the client receives the best possible results and that the advisor does not run afoul of his or her fiduciary duties.
In light of the pending Department of Labor fiduciary standard that may apply in the case of annuity sales, it is more important than ever that advisors are equipped to advise the client on the financial repercussions of an annuity exchange—including the associated fees and commissions that can make a new product financially unappealing.
The 1035 Annuity Exchange: Tax Implications
In general, the original owner of a nonqualified annuity product can 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. This is the case even if the new annuity has features that were not attached to the old product (such as a guaranteed withdrawal benefit or long-term care rider).
If the client instead chooses to surrender an undesirable annuity, he or she will owe taxes on any gain realized at the time of surrender. If the client has only held the annuity product for a few years, this gain might not be substantial—but it can still be an influential consideration in the cost-benefit analysis that must be undertaken when determining whether an exchange is the most advantageous strategy.
A client may wish to exchange an existing variable annuity contract for a variety of reasons—poor performance of the underlying accounts being an important issue for many. Other clients, however, may be more interested in exchanging a variable contract for one with features that better suit their needs.
Some of the variations on guaranteed minimum income and withdrawal benefits that can currently be purchased in conjunction with an annuity might not have been available when the client originally purchased the contract. On the other hand, some clients may simply wish to transfer their limited funds into a type of fixed annuity in order to simplify their investments or begin annuitizing the product immediately.
New types of indexed annuities have also been developed in order to allow the client to take advantage of the potential for market growth with limited risk—some of these products are tied to more than one index (for example, using both a stock index and a bond index), which can appeal to customers looking to mitigate risk.
Other clients may be dissatisfied with the insurance company itself—in recent years, many clients have received notices informing them that their investment choices are being limited to those that are very conservative. Some clients have even faced buyout offers from insurance companies looking to exit, or limit exposure to, the variable annuity business.