Annuities offer the benefit of income payments for a fixed period or the rest of your life, but you don’t start receiving these payments until you annuitize the contract. You can instead choose to take the cash value of the annuity as a lump sum at any time up to the annuitization date. You may be able to transfer the lump sum in a way that defers taxes.
Lump Sum Payouts
The cash basis of your annuity is the amount of cash you, and possibly your employer, contribute to the contract, plus the income earned on the contributions. Many annuity contracts charge surrender fees that can begin at 10 or 15 percent and slowly decline each year. If you take a distribution as a lump sum during the surrender period, the annuity provider deducts the surrender fee before turning over the remaining cash value. The tax bill on the payout is the amount in excess of the nondeductible contributions -- known as the cost basis -- made to the annuity.
Qualified annuities reside in employer retirement plans or individual retirement accounts. You may receive a lump sum distribution from an employer annuity when you leave a job. If you don’t roll over this money into another employer plan or into an individual retirement account within 60 days, you’ll have to include the distribution in your taxable income. Furthermore, if you’re younger than 59 1/2, you also might have to pay a 10-percent penalty tax for early withdrawal. Employer annuities require a 20-percent withholding of lump-sum distributions. You can avoid the deadline and withholding by arranging a trustee-to-trustee transfer instead of taking a cash distribution.
You can buy a nonqualified annuity contract directly from an issuer. Whereas the contributions to a qualified annuity are tax-deductible, you pay the premiums on a nonqualified annuity using after-tax dollars. Surrender fees will apply if you cash out a nonqualified annuity during the surrender period. The portion of the payout that exceeds your cost basis is taxable income, and you can’t roll a nonqualified annuity into an IRA to defer the tax bill. Once you receive the cash, you have no possibility of performing a tax-free transfer to another nonqualified annuity.
Section 1035 Exchanges
You can transfer tax-free the cash value of your nonqualified annuity to another contract through a Section 1035 exchange. To use this procedure, you must arrange a direct transfer of the surrender value between the old and new contracts rather than taking a lump-sum payment. Surrender fees will apply if you do the transfer during the surrender period. The cost basis of the old contract transfers to the new contract. You can also use a Section 1035 exchange to transfer an annuity’s surrender value to a long-term care policy.
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