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Question

Difficulty: MediumAnnuities and Insurance-Based Products

An investor who owns a non-qualified variable annuity decides to replace it with a different variable annuity offered by another insurance company to access better subaccount investment options. The full contract value is transferred directly from the existing annuity issuer to the new annuity issuer via a Section 1035 exchange without any cash distribution to the investor. What are the federal income tax consequences of this transaction in the year of the exchange?

  1. The exchange is treated as a tax-free transaction, deferring recognition of all accumulated gains.Answer
  2. B
    Accumulated earnings are fully taxable as ordinary income, but any IRS early withdrawal penalty is waived.
  3. C
    The growth portion of the contract is taxed as a long-term capital gain in the year the transfer occurs.
  4. D
    The entire surrendered contract value is subject to a 10% IRS tax penalty, regardless of the owner's age.

Answer

The exchange is treated as a tax-free transaction, deferring recognition of all accumulated gains.
Under IRS Section 1035, an investor can exchange an existing annuity contract for a new annuity contract without incurring immediate income taxation on built-in earnings. To qualify for tax-free treatment, the contract values must move directly between insurance companies without the contract owner receiving a cash distribution.

Step-by-Step Solution

1
Identify the transaction type described in the scenario.
The investor is executing a direct trustee-to-trustee transfer of a variable annuity contract to another variable annuity contract.
Internal Revenue Code Section 1035 explicitly governs exchanges between like-kind insurance products.
2
Evaluate whether any taxable event or 'boot' occurred.
No cash or non-qualifying property was distributed directly to the investor.
Direct transfers between annuity issuers preserve the tax-deferred status of the underlying earnings.
3
Determine the resulting tax obligation for the current tax year.
Zero tax liability and zero IRS tax penalties are triggered by the transaction.
Under Section 1035 rules, tax recognition on built-in gains is postponed until actual distributions take place.

Key Concept

Section 1035 Tax-Free Exchange Rules for Annuities
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Topics

Annuities and Insurance-Based Products

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