In This Case, the IRS Gets it Right!

About 40 million investors have over $2.2 trillion in retirement savings in the form of deferred annuities. As part of our Savings2Income planning method, we are focusing on the portion of the deferred annuity market with market-based account values – market-value adjusted annuities, and variable annuities. These annuities can be integrated within a Plan for Retirement Income together with Rollover IRA and tax managed accounts.

The majority – over $1.6 trillion – of these market-based annuities is in variable annuities. For many investors, a variable annuity represents a healthy percentage of their financial assets held outside a Rollover IRA or 401(k). So what is Section 1035 of the Internal Revenue Code, and how can it help you?

As background, a variable annuity offered outside a Rollover IRA enables investors to set aside money that has already been taxed, and to invest in a choice of mutual funds, all the while deferring taxes on investment returns until funds are withdrawn. Section 1035 of the Internal Revenue Code can help in the management of these investor’s savings in two very specific ways:

  1. If the investor is unhappy with his/her original contract and becomes aware of a more suitable alternative, the investor can exchange the old contract for a new contract, and at that point not incur taxes on any gain in the original contract.
  2. If the investor is happy with his/her contract but his/her company does not have the most competitive payout annuity rates, the investor can exchange part of the original contract for a new contract from another insurer – again without incurring taxes on any gain on the portion exchanged until annuity payments are received . In fact the investor can make these partial exchanges several times, and thus come up with best results

The annuity industry has not been singled out for special treatment, since this methodology is applied, for example, in the Rollover IRA market– with its $5 trillion in assets. A Rollover IRA can be transferred in full or in part, and taxes are deferred until amounts are received as income. I describe the entire process as “pay no tax before income is received”.

The 1035 exchange is a straightforward transaction. An application is submitted to the prospective new company, which will then handle the exchange processing with the original company. Also, there are certain state regulatory forms that have to be completed.

Importantly, for the 1035 exchange to be most beneficial, any surrender charges from the original company should be avoided. Also, any elimination or diminution of product features on the exchange should be evaluated very carefully.

Bottom line, while Congress is taking shots at the IRS and the tax code, here’s an opportunity that works well, and very few people seem to know about it!