As a combination insurance product and investment vehicle, variable annuities have long been popular with investors looking to set aside money for retirement or other long-term goals.
The product’s appeal stems from features such as tax-deferred growth and insurance provisions such as guaranteed lifetime payment options and a guaranteed death benefit.
Variable annuities are able to offer benefits not available to investors in taxable investments like mutual funds, which have made them especially attractive to investors looking to set aside funds for retirement.
In this article we’ll take a deeper look at how variable annuities function and also discuss how you can make a tax-free exchange from one variable annuity to another annuity product using a Section 1035 exchange.
Variable Annuity Basics
Variable annuity takes the form of a contract entered into between you as the contract owner and the insurance company sponsoring the annuity.
The primary benefit of variable annuities is the contract provides that the insurer will make periodic payments to you, either right away or at some later date.
You can make a single investment in a variable annuity or a series of investments over time.
Variable annuities differ from fixed annuities in that they offer investment subaccounts similar to mutual funds or ETFs (exchange-traded funds) which invest in securities such as stocks, bonds, and money market instruments. They also typically offer a fixed-interest account which pays an interest rate based on prevailing rates offered by similar products.
Unlike a fixed annuity, the principal amount of a variable annuity will fluctuate in value in response to the performance of the investments in the subaccounts in which you have chosen to invest.
While variable annuity investment accounts typically perform similarly to mutual funds, these products differ from mutual funds in three main ways.
Variable Annuity vs Mutual Fund
- A variable annuity can provide you (and your spouse or other beneficiary) with lifetime income payments. This helps reduce what is known as longevity risk, or the risk that you will outlive your income after you retire.
- A variable annuity offers a guaranteed death benefit that provides that your beneficiary will receive a certain specified amount, generally at least the amount you invest in the product, and sometimes more if a “step-up” death benefit is offered.
- Variable annuities offer tax-deferred growth. Thus, no current taxes are due on profits earned in the account over the course of a year. Transfers between investment subaccounts within a variable annuity can also be made free of any taxation on gains realized when making the transaction.
These features are covered in greater detail below.
Tax-Deferral and No Contribution Limits
Because variable annuities are insurance products, they benefit from favorable tax treatment, enabling tax-deferred growth of funds invested in these products.
Funds growing tax-deferred compound more rapidly than if taxes had to be paid on the earnings yearly.
Coupled with a lack of contribution limits, tax-deferral makes variable annuities a potential means of investing large sums of money for retirement.
Retirement plans such as 401ks and IRAs have strict contribution limits, so investors looking to set aside extra amounts for retirement often use variable annuities for this purpose.
In some cases, it may make sense to invest funds that are in a retirement account such as a 401(k) or IRA in a variable annuity to take advantage of features such as the guaranteed death benefit and lifetime income payments.
Please note, however, that because these accounts are already tax-deferred, such investments should not be made in variable annuities for tax reasons – there is no additional tax benefit in investing 401(k) or IRA funds in a variable annuity.
Guaranteed Death Benefit
Variable annuities typically guarantee that your beneficiaries will get no less than the amount you originally invested in the annuity upon your death, minus any withdrawals. This is known as the guaranteed death benefit.
Many variable annuity sponsors will offer an adjustable guaranteed death benefit that enables the amount covered by this provision to rise to the account’s value at the end of a period.
This is called a “step-up” provision.
If the investments in your variable annuity grow in value, this provision enables the increased value to become the new base level for the guaranteed death benefit.
This enables you to “lock-in” growth in the account so that even if the value of the variable annuity subsequently declines your death benefit amount won’t fall with it.
Lifetime Income Option
As an insurance product, variable annuities can offer lifetime income to the policyholder, based on the value of the account.
In some cases, different insurance companies will offer certain guaranteed growth levels during the accumulation phase.
Once withdrawals start, income payments are either set at a fixed level based on the value of the account at the time you elect to take income from, or annuitize, the account, or they will vary according to the performance of the investments in the variable annuity.
There are two main phases of an investment in a variable annuity. The accumulation and payout phases.
Accumulation Phase
During the accumulation phase, your purchase payment funds are invested in the variable annuity in investment options of your selection.
You can generally choose from a variety of growth and income-oriented subaccounts that invest both in U.S. and international stocks, bonds and money market instruments as well as a fixed rate option.
Earnings are reinvested back in the investment subaccount in which they are generated.
The fixed rate offered by the insurance company is typically guaranteed for a period of time and is regularly reset to reflect competitive market interest rates.
Complete information about the investment options and expense ratios charged for different investment subaccounts can be found in a variable annuity’s prospectus.
Payout Phase
During the payout phase, assets generated in a variable annuity are paid out to the policyholder, either via annuitization or through partial withdrawals from the product. You can take a lump sum withdrawal or pull the funds out over time.
If withdrawals are taken prior to age 59 1/2., there may be penalties on the earnings in the variable annuity.
As mentioned previously, you typically have the option of choosing whether to have your payments sent in a fixed amount per payment based on the value of the account at the time you start the withdrawal process or based upon the performance of the investments in the account.
You can usually choose to have payments guaranteed for a certain time, a “period certain”, or opt for lifetime income payments. The former will provide higher payments than the latter.
Some annuities prohibit any additional withdrawals from your account once you elect to start taking income.
And other annuities are structured as immediate annuities, where there is no accumulation phase and income payouts start immediately.
1035 Exchanges
Section 1035 Exchanges enable annuity holders to move their annuity assets from one annuity provider to another without having to pay taxes on the earnings in their accounts.
These exchanges take advantage of section 1035 of the tax code, which allows such exchanges as long as certain conditions are met.
Making such an exchange allows you to get out of a variable annuity that no longer serves your purposes, for whatever reason.
It could be that the performance of the investments in your variable annuity has been disappointing, or you might want to take advantage of an income rider or other special feature offered by another variable annuity.
Section 1035 exchanges for annuities allow you to avoid some or all of the negatives that can accompany cashing out, or surrendering, your policy.
1035 Exchanges can potentially avoid:
- Payment of ordinary income tax on the entirety of the gains realized within the policy.
- Potential surrender fees if you surrender the policy before the penalty phase period (typically from 1 to 10 years) ends.
- A 10% penalty charged by the IRS on any earnings if you surrender the variable annuity contract prior to turning 59 ½ years of age.
The beauty of a Section 1035 exchange is that it enables you to avoid any tax consequences while moving one annuity to another one as long as the funds being exchanged do not pass through the annuity owner’s hands.
This means that you can’t take the money from your old variable annuity and use it to write a check to purchase the new annuity – the funds instead must be sent directly from the insurer which sponsors the old annuity to the sponsor of the new one.
Additionally, to stay within the regulations the owner and annuitant on your old variable annuity contract must be the same on the new contract when performing a Section 1035 exchange.
However, after the exchange has been made you are free to make changes to these designations.
Why You May Want to Do a Section 1035 Exchange
Anytime you are thinking about moving to an entirely new insurance contract you should make sure to give serious consideration to all of the pluses and minuses of the move.
Scenarios where a Section 1035 exchange might make sense include:
- Moving from a variable annuity to a fixed annuity
- To move to an annuity with better performance
- To take advantage of more extensive investment options, for instance global stocks and bonds, at the new annuity
- To gain access to better payout options such as guaranteed lifetime withdrawal benefits
- To take advantage of death benefit options such as the payment of lifetime income to policy beneficiaries
When to Avoid Making a Section 1035 Exchange
- When you don’t need to upgrade to more elaborate options such as guaranteed lifetime withdrawal benefits
- When the performance of the new policy is not significantly better than that of the old one
- When the surrender charge for transferring your old policy is high enough to outweigh the benefits of moving to the new one
- When any premium bonus paid for moving to a new policy is not enough to pay for the penalties charged for leaving the old one
- When your existing contract is valued at less than you originally invested in it. If you’re over 59 ½, you might be better off surrendering the policy, if surrender charges have expired, and realizing a tax loss on the investment.
Other considerations
Other issues to consider when looking into making a Section1035 exchange are the sales charges or commissions your broker may earn on the transaction and the establishment of a new surrender fee time period.
For instance, if your original variable annuity had a seven-year surrender charge period, or contingent deferred sales charge (CDSC), as it is sometimes called, and it has expired, by making a 1035 exchange you may incur another CDSC.
If you don’t intend to withdraw funds from the variable annuity anytime soon this may not matter, but if you are past age 59 ½ and looking to use some of these funds soon it could be a problem.
In some cases, insurance companies will waive or lower the surrender charge period on Section 1035 exchanges, but this is not the norm, so be sure to verify if and how long any surrender charge will apply when considering making an exchange.
Summing Up
Variable annuities have a number of features which make them attractive savings vehicles.
However, they are best utilized for long-term savings, as their favorable tax treatment and surrender charges make them most effective when used in this manner.
Because of their long-term orientation and the surrender charges generally attached to them, investors should do extensive due diligence before purchasing a variable annuity.
Sales of variable annuities are subject to oversight by a variety of regulatory bodies, including the Securities & Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), state insurance departments, and state securities administrators.
Make sure that you look into the following issues when considering buying a variable annuity contract:
- Expenses: What are the total annual costs associated with an investment in the variable annuity? This will include mortality and administrative costs as well as the expenses connected with management of the investments in the contract.
- Surrender period and charges: How long does the surrender period last and how much is the surrender charge? In many cases surrender charges will decline over the course of the surrender period. For example, a seven-year surrender charge period might work like this: 7%, 6%, 5%, 4%, 3%, 2%, 1%, 0.
- Features and options: Check to see if a contract you’re considering has all of the features you are looking for such as lifetime payment options, a step-up guaranteed death benefit, a variety of investment options, etc.
If a variable annuity you’ve invested in no longer suits your needs for whatever reason, a Section 1035 exchange is generally the best option for moving the funds you have there to another contract.
As previously mentioned, variable annuities are best suited for long-term investing, so make sure that you are prepared to invest for the long haul when placing funds in such a contract.
