Tax Changes for 2010 - Tax Free 1035 Exchange (Smartmoney.com)

The Tax Guy by Bill Bischoff
Published September 30, 2009

Swapping Annuities Tax-Free

Barely a year since the Dow Jones Industrial Average marked its largest single-day drop in history, the memory of watching their savings evaporate still makes many folks shiver. It’s no surprise that interest in annuities is on the rise. These investments tout guaranteed income in retirement and, in the case of variable annuities, even promise market gains without the risk.

Tax-wise, the advantage of investing in annuities is you don’t have to report any of the accumulated income on your tax return until you actually receive a payout.

But when you surrender an annuity contract (or turn it in for cash), the general rule says you must report the entire difference between the cash received and your basis in the contract as ordinary income – at a federal tax rate as high as 35%. (Your basis equals your investment in the contract minus any basis included in earlier payouts. If you haven’t received any payouts, your basis equals your entire investment.) To add insult to injury, the income from surrendering an annuity before age 59½ will generally get socked with a 10% penalty tax, too. This unfavorable treatment will apply even to a variable annuity with accumulated stock and mutual fund gains that would have been taxed at low capital gains rates in a taxable brokerage firm account.

One way to get a tax-free deal is to exchange your existing annuity contract for another one. Why would you want to do that? Maybe you’re unhappy with the expense charges built into your current annuity and have found one with lower costs. Or you changed your mind about the type of annuity that best fits your needs. (Whatever your reasons, keep in mind that taxes are just one factor to consider with annuity swaps. For example, a tax-free exchange may not make financial sense if your current annuity still has surrender charges built in. So it’s best to run this decision by an independent financial advisor.)

Here’s what you need to know about swapping annuities without taking a tax hit.

The Basics
Section 1035 of the Internal Revenue Code allows you to exchange one annuity contract for another without triggering any taxable income. Note, however, that there must be an actual exchange of contracts for this tax-free treatment to apply, meaning that no cash should be passing through your hands. If you simply cash out the old contract and use the money to buy the new contract, it’s treated as a taxable surrender of the old contract.

Also, the old annuity contract and the new one must both be payable to the same person.

Even when you successfully arrange for a tax-free exchange, the insurance company that issued the old contract may send you (and the IRS) a Form 1099-R that reports in Box 1 the total amount paid out from the old contract. However, if the old company knows you made a tax-free exchange, Box 7 of the Form 1099-R should show Distribution Code 6 (indicating you made a tax-free Section 1035 swap). If the old and new contracts are both from the same company, there's no requirement to issue a Form 1099-R.

Exchanges Qualifying for Tax-Free Treatment
You can make a tax-free exchange of an annuity contract issued by one company for one issued by a different company.

You can also make a tax-free exchange of one type of annuity contract for another -- say a garden variety fixed annuity for a variable annuity or vice versa.

You can even make a tax-free partial exchange of one annuity contract for another contract by arranging for a direct transfer of a portion of the balance from the old contract to purchase the new contract. However, if you only exchange part of the old contract and cash out the rest, the cash-out part of the deal will be a taxable transaction. If you’re interested in making a partial tax-free exchange, please don’t pull the trigger before consulting with your tax adviser. (Tell him or her to check out IRS Revenue Procedure 2008-24 for the government's guidelines on how to accomplish a partial tax-free exchange.)

Starting in 2010, tax-free treatment will also be allowed for an exchange of an annuity contract for a qualifying long-term-care contract. That’s something to keep in mind for next year.

You’re also allowed to make a tax-free exchange of a life insurance contract for an annuity contract, but it’s a one-way street. You can’t make a tax-free swap of an annuity contract for a life-insurance contract. That would be treated as a taxable surrender of the annuity contract.