With the market’s steady rally during the past five years, many variable annuity holders may find they have a large taxable gain inside their annuity. If you find yourself in this situation, it is important to understand there are options available that could allow you to move your money out of the variable annuity and into a less volatile, fixed annuity product without triggering tax consequences today.
Internal Revenue Code Section 1035 allows you to exchange an existing variable annuity contract for a new annuity contract without paying tax on the income or the investment gains in your current variable annuity account. With the market at all-time highs, this provision of the tax code may allow you to re-allocate your investment into a product that is not market driven, effectively protecting the gains you have accrued while continuing to defer the tax liability within the annuity.
The key element of this transition is making the decision to move your money from the variable annuity into a fixed annuity of some kind. The two most common fixed annuity contracts are deferred and immediate annuities. In contrast to most variable annuities, fixed contracts pay a stated interest rate and/or pay out a stated income stream over a specified period of time. This type of annuity has several viable uses that can fit in well with your financial plan, if evaluated appropriately.
Thanks to the Pension Protection Act of 2006, you may also exchange your annuity for a fixed annuity with an added long-term care feature. Because of the tax-free nature of long-term care benefits, a 1035 exchange into this product could effectively make the taxable gain disappear upon a triggering long-term care event. It is important to make sure the long-term-term care feature meets the criteria as a “tax qualified” policy, which a vast majority of policies already meet this criteria today. The annuity should be non-qualified, or originally purchased with after-tax funds. As a result, you gain a more preferable tax treatment for funding your long-term care coverage, if ever needed, because the benefits of the long-term care policy are received tax-free, and you still retain the core benefit of a fixed annuity if long-term care benefits are never used.
There are viable, tax-favored options for individuals who own variable annuities. In many cases, it may be best to simply surrender the annuity and re-position the funds into more appropriate investment vehicles. If you find yourself with a large tax liability inside a variable annuity, talk with a financial adviser about the options available to you via a 1035 exchange. Annuities are investment products that should be periodically evaluated in context with your overall financial plan.
William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.