An investor concerned about inflation decides to exchange an existing fixed annuity contract for a new variable annuity contract through a Section 1035 exchange. Which of the following statements accurately describes the primary tax outcome and financial impact of this transaction?
- AThe transaction triggers immediate taxation on accumulated earnings as ordinary income plus a 10% IRS early withdrawal tax penalty.
- The transfer is executed on a tax-free basis, although the investor may be subject to a new surrender charge period on the new contract.Answer
- CThe exchange allows any accumulated investment losses within the contract to pass through to the investor to offset ordinary personal income.
- DThe exchange eliminates market risk while guaranteeing that future withdrawals from the variable annuity will be entirely tax-free.
Answer
The transfer is executed on a tax-free basis, although the investor may be subject to a new surrender charge period on the new contract.
Under Section 1035 of the Internal Revenue Code, an investor can exchange an existing annuity for a new annuity contract without triggering immediate tax liability on accumulated gains. However, representatives must consider that the new contract will generally initiate a new surrender charge period and potential surrender fees.
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Key Concept
Section 1035 Exchange Mechanics and Tax Treatment