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Difficulty: MediumAnnuities and Insurance-Based Products

An investor transfers funds directly from an existing variable annuity contract into a new variable annuity contract issued by a different insurance company under an IRS Section 1035 exchange. Which of the following statements correctly describes the federal tax implication of this transaction?

  1. The exchange is executed on a tax-deferred basis without triggering immediate federal income tax or IRS early withdrawal penalties.Answer
  2. B
    The earnings portion of the existing contract is subject to immediate taxation as ordinary income, but the 10% IRS early withdrawal penalty is waived.
  3. C
    The transfer is treated as a LIFO distribution, making all accumulated growth taxable as capital gains in the year of the exchange.
  4. D
    The transaction qualifies for tax-deferred treatment only if the contract owner has reached age 59½ prior to the transfer.

Answer

The exchange is executed on a tax-deferred basis without triggering immediate federal income tax or IRS early withdrawal penalties.
IRS Section 1035 allows for tax-free exchanges of annuity contracts provided the transfer takes place directly between contract issuers. The investor maintains tax-deferred status on all accumulated growth, avoiding immediate ordinary income tax and IRS penalty fees.

Step-by-Step Solution

1
Identify the transaction type
The investor is executing a direct transfer between variable annuity contracts under Section 1035 of the Internal Revenue Code.
IRS Section 1035 specifically governs tax-free exchanges of insurance and annuity contracts.
2
Apply Section 1035 tax rules
Direct transfers between annuity contracts preserve tax deferral on all accumulated earnings.
Because funds move directly from issuer to issuer without a constructive receipt of cash by the investor, no current ordinary income tax or 10% IRS early withdrawal penalty applies.

Key Concept

Taxation of Section 1035 Exchanges for Variable Annuities
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Topics

Annuities and Insurance-Based Products

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