What is a Variable Annuity?
A variable annuity is a tax-deferred investment vehicle typically used for retirement planning. The variable annuity allows you to choose from several investment options, which will pay a certain amount of income in your retirement on a periodic basis. The amount of income received with each annuity payment depends on how the investments are performing and the terms of the annuity contract. Fundamentally, the payout on a variable annuity can vary from month-to-month. Unlike a fixed annuity, a variable annuity does not guarantee a payout (unless you have a rider to the contract that provides for the same).
What Is A 1035 Exchange?
Section 1035 of the IRS Code permits an individual to exchange one annuity for another, without paying income tax on the gains. For a 1035 Exchange to qualify, the funds must pass directly from the prior annuity company into the new annuity company. Thus, you cannot cash or use the funds from the prior annuity to qualify under §1035 of the IRS Code. Another stipulation to the 1035 Exchange is that the annuitant and the owner must remain the equivalent on the new annuity contract. When it comes to exchanging variable annuities there is no limit to the number of old contracts that can be exchanged, or rolled into the new contract.
The Risks of Variable Annuity Exchanges
There are many risks associated with variable annuity purchases and variable annuity exchanges. Most variable annuities have high fees, expenses and pay large commissions to the individual selling the product. Many of these fees are hidden from the investor and not properly disclosed during the sale to the client. Variable annuities have a risk of loss where you could lose your original investment if the investments within the annuity under perform. Investment options within the variable annuity may be restricted or limited. If you have a need for liquidity, you may have to pay a large surrender charge (up to 10% of your investment in some cases) in order to gain access to your original investment. More importantly, if the insurance company who guarantees the annuity experiences financial distress, there is a risk it will not be able to pay out per the terms of the variable annuity contract.
With respect to variable annuity exchanges, it is important to determine if the benefits of the exchange outweigh the costs. If you exchange contracts, you may be required to pay surrender charges on the old annuity if you are still in the surrender period. In addition, a new surrender charge period may begin when you exchange into the new annuity. The rate of return may vary between contracts and you may be required to pay higher fees and costs under the new contact.
Remember, financial advisors are paid very large commissions on the sale of variable annuity contracts and have a financial incentive to sell these products to their clients.
The Benefits of a 1035 Exchange
The primary benefit of a 1035 exchange is that it lets the policy owner trade one product for another with no tax consequence. Other benefits that are associated with a 1035 exchange are the introduction of certain riders to the insurance contact that might not have existed on the prior contract. For example, the new contract could offer a living benefit that provides the investor guaranteed lifetime withdrawals. There are also death benefit riders that provide the contract’s beneficiaries with a guaranteed lifetime income payment.
Why Do A 1035 Exchanges?
Again, the real draw is for tax savings on the gains realized on the prior annuity contract. There are a few other reasons why you may want to exchange your old variable annuity for new one. The first reason is that many annuity contracts now offer their clients a premium. This premium, or bonus, is based on the value of the annuity contract. The bonus usually ranges between 1 to 5 percent for each purchase payment made to the insurance company. There have also been new developments with variable annuities in recent years. Some of the insurance features that are associated with newer products are more advantageous than older annuity features. Newer annuity contracts tend to offer more investment options, better death and living benefits, and reduced contract fees and expenses. All of these variables are valid reasons for exploring a 1035 exchange.
When You Should Not Do A Variable Annuity Exchange
Below are a few situations when you should not exchange a variable annuity:
- If the fees for the new contract are higher than the fees for the old contract;
- If the old annuity is worth less than what you originally paid for it;
- If you have a need for liquidity; and
- If your financial advisor is using high pressure sales tactics to influence you, or if the advisor creates a sense of urgency for the exchange.
If you are considering a variable annuity exchange, you should review the pros and cons so that you can make an informed decision that best suits your financial situation.
Variable annuities are extremely complex investment products, which commonly lead to misrepresentations by financial advisors and sales practice violations. Variable annuities are not suitable for investors with short-term goals as there are typically large surrender charges if the client wants to gain access to the money invested. The commissions and fees paid to financial advisors are typically larger compared to other investment products, which often leads to abusive sales practices.
If you believe you have been sold an unsuitable or inappropriate variable annuity, or if your financial advisor encouraged you to exchange an older annuity for a new one and you would like to speak to an attorney, please contact our office.