An investor who is 52 years old holds a non-qualified variable annuity contract that is currently subject to a 4% insurance company surrender charge. Seeking lower subaccount management fees, the investor completes a direct trustee-to-trustee contract exchange under Section 1035 of the Internal Revenue Code into a new variable annuity. Which of the following statements accurately describes the tax consequences and insurer fees resulting from this transaction?
- The exchange is executed without triggering immediate income tax liability, but the surrender charge imposed by the original insurance company still applies.Answer
- BThe exchange avoids all surrender charges imposed by the existing insurer, but accumulated growth becomes immediately subject to ordinary income tax and the 10% IRS early withdrawal penalty.
- CThe transaction is fully exempt from insurer surrender charges and tax consequences because federal law mandates a total fee waiver for direct subaccount replacements.
- DThe transaction triggers ordinary income taxation on contract earnings under last-in, first-out (LIFO) accounting, though the 10% IRS penalty is waived due to the direct exchange format.
Answer
The exchange is executed without triggering immediate income tax liability, but the surrender charge imposed by the original insurance company still applies.
Under IRS Section 1035, an investor can exchange a variable annuity for another annuity without triggering immediate taxation on earnings or incurring the 10% IRS penalty for premature distributions before age 59½. However, Section 1035 applies solely to federal tax treatment; it does not relieve the contract owner from private contractual liabilities, such as contingent deferred surrender charges (CDSCs) assessed by the existing annuity provider.
Step-by-Step Solution
Key Concept
Section 1035 Annuity Exchange Rules & Surrender Charges
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