Rollovers: Saving Money with the 1035 Exchange

Have you just retired? Recently switched jobs? Perhaps you have an existing investment, such as a non-qualified annuity, that is no longer paying a competitive interest rate or lacks the liquidity you need. Whenever your life and personal needs change, it is a good idea to review your investment portfolio to make sure it is still in line with your financial goals. After all, we're talking about the money you and your loved ones have to live on.

But don't worry. Even if you decide that certain investments need to be changed, you have options. You can simply liquidate your investment funds (albeit with tax implications), or you can "rollover" the account values to a new annuity altogether.  This second option takes advantage of a provision in Section 1035 of the tax code. A 1035 Exchange allows you to directly transfer an existing account to a brand new account without triggering a taxable event. There are strict rules you must follow, and you may have to adhere to a waiting period before the rollover can be finalized. A 1035 exchange is not always the simplest of maneuvers, but the advantages it offers may prove worthwhile.

Consider the alternative. You will likely have tax implications if you decide to cash out your annuity contract without using the 1035 exchange. First, you will be hit with a tax on the interest earned immediately upon the withdrawal of the existing contract’s funds (the principal is not taxed). In addition [to income taxes], prior to the age of 59 ½, there is a 10% IRS penalty on the withdrawn profits. Finally, insurance companies impose surrender charges if you withdraw funds early. So, double check with your company regarding the length of your contract's surrender charge period.

Also, check with the insurance company about insurance for the annuity. Due to the nature of the variable annuity, the principle is insured, sometimes at each anniversary date to catch the highest price (always at the minimal original invested amount less withdrawals).

However, many investors realize that the tax-free advantage of the 1035 Exchange outweighs potential disadvantages. In fact, the official wording states, "No gain or loss shall be recognized on the exchange" of an annuity (from Title 26, Subtitle A, Chapter 1, Sub Chapter O, Part 3, Section 1035). For example, you may transfer from one annuity to another, from a life insurance contract to another life insurance contract or endowment policy, and from a life insurance contract to an annuity. The one instance in which an exchange like this is not valid is when you exchange your annuity for a life insurance policy. Always remember to completely exchange the existing policy for a new policy and not for cash.

At what point in time should you roll over your annuity account to a new annuity account? Ultimately, this is a personal decision that depends on individual circumstances. For instance, it may make sense to do this when you change jobs, at the time your new company initially allows you to roll over your retirement account.

I contacted Immediate Annuities.com to buy one of my immediate annuities. They were prompt, very responsive, paid attention to detail, understood my objectives, and were superb when it came to staying on top of seeing the funds transfer and issue of new policy documents through to completion.

Dr. David Babbel Professor Wharton School

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A 1035 exchange is also a great option if your existing contract’s interest rate is lower than a new, more efficient contract. The rollover option gives you added flexibility in finding an annuity contract with a higher rate of return without worrying about tax implications. Of course, you should check interest rates in a timely manner. And you should always check with your insurance company to determine the penalties or surrender charges imposed for the exchange. Remember that even if your old annuity contract has matured past the surrender charge period, buying a new annuity contract will probably lock you into a new surrender charge period all over again.

Finally, keep in mind that rollovers may not be right for everyone — even if a new product or contract is marketed to you with appealing features. To help you decide whether to take advantage of the 1035 Exchange, consider all the advantages and disadvantages of this maneuver. Also, ask yourself if a 1035 Exchange is in the best interest of your portfolio and your overall retirement plan. But if you decide that the 1035 Exchange is appropriate, you will be able to avoid a taxable event, and thus retain a greater portion of funds in your portfolio.