Variable annuity contract distributions generally contain two components, taxable income and nontaxable return of basis (investment). However, distributions received before the annuity starting date (nonannuity distributions) are likely to be less taxpayer-friendly. Initially, these generally consist entirely of taxable income until all of the annuity contract’s earnings have been distributed. Subsequent payments are considered to be a nontaxable return of basis. Because of this issue, when an annuity owner must take a nonannuity distribution, the tax impact can be onerous.
Internal Revenue Code Section 1035 exchange has traditionally provided a federal tax-free mechanism to exchange one annuity contract for another annuity contract. This Section 1035 exchange, without recognition of gain or loss, is limited to cases where the person who is the insured or annuitant is the same in both contracts. Recent regulatory guidance offers a way to lessen the tax impact on nonannuity distributions using the Section 1035 exchange mechanism.
A person holding a highly appreciated annuity (one containing a large amount of built-up earnings) can lessen the tax bite using a two-step process. First, he or she makes a partial withdrawal from the original annuity by completing a partial exchange into another annuity. Next, he or she surrenders either annuity contract more than 180 days later to minimize the tax impact.
Example: Partial annuity exchange.
Pat originally invested $50,000 in an annuity, which has now grown to a fair market value of $200,000. If she withdraws $100,000 from this annuity, the funds will come first from her gain and will be taxed as ordinary income. So, instead, Pat makes a Section 1035 (tax-free) exchange with half of the original annuity into a second annuity worth $100,000. Her basis in each annuity is split proportionally. Accordingly, she has a $25,000 tax cost (basis) in each $100,000 annuity after the partial Section 1035 exchange. If Pat surrenders one of the annuities in full more than 180 days after the date of the Section 1035 exchange, she receives a $100,000 distribution that is considered to be $25,000 return of basis and $75,000 of ordinary income. This is a better result than receiving $100,000 of ordinary income without the partial Section 1035 exchange.
Observation: The new annuity contract(s) received in the partial exchange typically will have a fresh surrender charge period. For this reason, Pat should surrender the old annuity first rather than the new contract subject to the penalty.