The rules concerning tax-free exchanges of non-qualified annuities changed in 2013, when the Internal Revenue Service published Private Ruling 201330016. Under the ruling, a beneficiary can perform a Section 1035 exchange on an inherited annuity, but the exchange must conform to all the other rules that apply to inherited annuities. Non-qualified annuities can’t be rolled over into an individual retirement account or other qualified annuity.
You purchase a non-qualified annuity directly from the issuer, usually an insurance company. Premiums are not tax-deductible, but earnings grow tax-deferred until they’re distributed. The IRS might slap distributions the owner receives before age 59 1/2 with a 10 percent early withdrawal tax. On the annuity date, the owner can convert the contract’s cash value into a lump-sum distribution or annuitize the cash value into a series of periodic payments that continue for a fixed period or until the owner dies. The owner can name one or more beneficiaries to receive any death benefits or guaranteed payments. A joint and survivor annuity has two co-annuitants, and payments continue even after the death of one annuitant.
Section 1035 Exchanges
Section 1035 of the Internal Revenue Code allows owners of non-qualified annuities to exchange their contracts for new ones tax-free as long as the owner hasn't annuitized the contract. The cost basis -- the amount the owner paid into the non-qualified contract -- transfers to the new contract. If the transfer occurs during the first several years of the contract, a surrender charge may apply. Surrender charges might exceed 15 percent initially and then slowly decline over time. Surrender charges are not tax-deductible.
If you inherit the death benefit from an owner’s single-life annuity, you have up to five years to completely withdraw the money from the contract. You don’t have to pay taxes on the money until you withdraw it, and you only pay taxes on the amount in excess of the contract’s cost basis. You can’t roll the money into a tax-free account such as an IRA, but you can convert the death benefit into an annuity contract and receive payouts over your expected lifespan. Private Ruling 201330016 clarified that you can exchange the lump sum distribution or the annuity contract you create for another annuity tax-free using Section 1035. The new annuity must pay out at least as quickly as the old one -- you can’t use Section 1035 to lower your annual tax bill.
Joint And Survivor Annuities
The beneficiary of a joint and survivor annuity continues to receive monthly income for a fixed period or for life. If the annuity has a lifetime period, payments may exceed the cash value of the contract. The beneficiary can use a Section 1035 exchange if the owner dies before annuitizing the contract. Once a contract has been annuitized, no cash value remains, just the promise of periodic income payments. When the contract is annuitized, the insurance company establishes an “exclusion ratio” by dividing the cost basis of the contract by the expected value of the contract’s payouts. The excluded portion of each income payment is tax-free, and the remainder is ordinary income. Beneficiaries of joint and survivor annuities continue to use the established exclusion ratio of annuitized contracts to figure their tax liabilities.
- Money Matters Radio: Qualified and Nonqualified Annuities
- U.S. Securities and Exchange Commission: Variable Annuities: What You Should Know
- Nerd’s Eye View: IRS Opens Door in PLR 201330016 for 1035 Exchange by Beneficiary of Fixed and Variable Inherited Annuities
- Insurance Providers: What Is an Annuity Exclusion Ratio?
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