Insurance companies offer annuities as investment contracts for policyholders to insure against the risk of outliving their savings. Investors can contribute to an annuity, growing their contributions tax-deferred, during the accumulating period. If an investor wants to change annuity plans during the accumulation period, the tax code permits direct rollovers to avoid recognizing any of the growth as taxable income with the transfer.
Named after the section of tax law that creates the transaction, Section 1035 exchanges are tax-free direct rollovers of non-qualified annuities. The new annuity company initiates the request by asking the current annuity company to liquidate and pay the balance of the annuity contract pursuant to Section 1035. The current company then issues a check payable to the new annuity company for the benefit of the owner, which the new company deposits into the newly established annuity contract. Although you can establish annuities as certain qualified retirement accounts, such as an Individual Retirement Annuity or Tax-Sheltered Annuity, different sections of tax law govern transfers of qualified annuities.
Fixed annuities offer, as the name suggests, fixed interest rates on your deposits. Conservative investors often employ fixed annuities to safeguard portions of their portfolio against the loss of principal and loss of purchasing power from inflation. The insurance company offering the fixed annuity guarantees the interest payments, but the guarantee is only as good as the credit of the company. Fixed annuities typically charge fewer management and administrative fees than variable annuities; however, fees can vary from company to company.
Structured more like mutual fund accounts, variable annuities allow investors to distribute their account balance among various subaccounts that are invested in the market. Because their money is invested in actively traded instruments, their account balances will go up or down with the underlying investment. Unlike a brokerage account, investors can redistribute investments tax-free. However, when the investor withdraws funds from the annuity, any growth is taxed as ordinary income rather than at the preferential long-term capital gains rate available to the brokerage account. Investors who anticipate withdrawing the funds when they’re in a lower tax bracket than when investing enjoy the largest after-tax benefit from choosing a variable annuity over direct investing.
When you want to conduct a 1035 exchange, you begin the process with the company you want to receive the money. They will send, either by mail or via a local representative, the appropriate paperwork you need to complete to request the liquidation. Typically, the paperwork will include a letter addressed to your current annuity company as well as an absolute assignment of the annuity over to the new company. If you are transferring into a new fixed annuity, you may also need to complete an application and several compliance-related forms, such as suitability questionnaires, state replacement disclosures and penalty or fee schedules. Your current provider may require that you complete a proprietary 1035 exchange request form before releasing the funds.
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