An investor holding a non-qualified variable annuity decides to replace it with a new variable annuity offering enhanced riders and a broader selection of subaccounts. If the contract replacement is executed as a direct transfer in full compliance with IRS Section 1035 guidelines, which of the following statements correctly describes the federal tax treatment of this transaction?
- The exchange is completed on a tax-deferred basis, resulting in no immediate federal income tax liability or penalty.Answer
- BAccumulated contract growth is immediately taxed as ordinary income, plus a 10% IRS early withdrawal penalty if the investor is under age 59½.
- CThe earnings portion of the original contract must be recognized and taxed as a long-term capital gain in the tax year the transfer occurs.
- DTax-deferred status is preserved only if the contract owner receives the surrender proceeds directly and reinvests them into the new annuity within 60 days.
Answer
The exchange is completed on a tax-deferred basis, resulting in no immediate federal income tax liability or penalty.
Under IRS Section 1035, an investor can exchange an existing annuity contract for another annuity contract without recognizing taxable income or triggering early distribution penalties. The cost basis and tax-deferred earnings of the original contract carry over to the new contract, provided the transaction is handled directly between insurance carriers.
Step-by-Step Solution
Key Concept
IRS Section 1035 Exchange Rules for Annuities