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Question

Difficulty: MediumAnnuities and Insurance-Based Products

An investor is considering transferring funds from an existing non-qualified variable annuity into a new variable annuity contract offering different subaccount options. If the transaction is executed as a Section 1035 exchange, which of the following statements correctly describes the tax implications and potential cost considerations for the investor?

  1. The exchange postpones immediate taxation on accrued growth, but the investor may still face surrender charges from the issuing insurer of the old contract.Answer
  2. B
    The accumulated earnings in the existing contract are taxed as capital gains, but federal law waives all surrender charges for Section 1035 transfers.
  3. C
    The transfer triggers ordinary income tax and a 10% IRS early withdrawal penalty on earnings unless the investor is over age 59½.
  4. D
    The exchange triggers immediate tax liability unless both the original and replacement contracts are issued by the exact same insurance company.

Answer

The exchange postpones immediate taxation on accrued growth, but the investor may still face surrender charges from the issuing insurer of the old contract.
Under Section 1035 of the Internal Revenue Code, an investor can exchange an existing variable annuity contract for a new variable annuity without triggering immediate tax consequences on accumulated earnings. However, the IRS tax code does not relieve the investor of contractual surrender fees that the existing annuity issuer may assess for early termination.

Step-by-Step Solution

1
Identify the tax rule governing Section 1035 exchanges for variable annuities.
Under Section 1035 of the Internal Revenue Code, exchanging one non-qualified annuity contract for another allows the owner to defer recognition of gain for federal income tax purposes.
IRS rules permit tax-free transfers between like-kind annuity products to avoid unfair taxation when updating or changing contracts.
2
Evaluate insurer-level penalties and contractual costs distinct from IRS tax rules.
Insurance contract surrender charges are independent of IRS tax treatment and may be assessed by the surrendering insurer if the contract is still within its surrender charge period.
Federal tax deferral under Section 1035 does not invalidate private insurance contract provisions such as contingent deferred sales charges (CDSCs).

Key Concept

Section 1035 Exchange Tax Deferral and Surrender Charge Mechanics
Estimated Time:1m 0s
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Topics

Annuities and Insurance-Based Products

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