Swapping Annuities Tax-Free

Barely a year since the Dow Jones Industrial Average marked its largest single-day drop in history, the memory of watching their savings evaporate still makes many folks shiver. It’s no surprise that interest in annuities is on the rise. These investments tout guaranteed income in retirement and, in the case of variable annuities, even promise market gains without the risk.

Section 1035 of the Internal Revenue Code allows you to exchange one annuity contract for another without triggering any taxable income. Note, however, that there must be an actual exchange of contracts for this tax-free treatment to apply, meaning that no cash should be passing through your hands. If you simply cash out the old contract and use the money to buy the new contract, it’s treated as a taxable surrender of the old contract.

Also, the old annuity contract and the new one must both be payable to the same person.

Even when you successfully arrange for a tax-free exchange, the insurance company that issued the old contract may send you (and the IRS) a Form 1099-R that reports in Box 1 the total amount paid out from the old contract. However, if the old company knows you made a tax-free exchange, Box 7 of the Form 1099-R should show Distribution Code 6 (indicating you made a tax-free Section 1035 swap). If the old and new contracts are both from the same company, there's no requirement to issue a Form 1099-R.

You can make a tax-free exchange of an annuity contract issued by one company for one issued by a different company.

You can also make a tax-free exchange of one type of annuity contract for another -- say a garden variety fixed annuity for a variable annuity or vice versa.

You can even make a tax-free partial exchange of one annuity contract for another contract by arranging for a direct transfer of a portion of the balance from the old contract to purchase the new contract. However, if you only exchange part of the old contract and cash out the rest, the cash-out part of the deal will be a taxable transaction. If you’re interested in making a partial tax-free exchange, please don’t pull the trigger before consulting with your tax adviser. (Tell him or her to check out IRS Revenue Procedure 2008-24 for the government's guidelines on how to accomplish a partial tax-free exchange.)

Starting in 2010, tax-free treatment will also be allowed for an exchange of an annuity contract for a qualifying long-term-care contract. That’s something to keep in mind for next year.

You’re also allowed to make a tax-free exchange of a life insurance contract for an annuity contract, but it’s a one-way street. You can’t make a tax-free swap of an annuity contract for a life-insurance contract. That would be treated as a taxable surrender of the annuity contract.