If your annuity is not a good fit, you can exchange it without penalties for one that is.
You Don’t Know What You Don’t Know About Insurance
We work with smart clients, and I know many well-informed professionals who work in the industry with me. However, in my opinion understanding insurance policies requires experience regardless of your background or day job. You might have experience with your health insurance after dealing with it your entire adult life, but most people’s long-term experience with insurance stops somewhere around there. I want to talk about financial insurance policies, which are distinct from health, property, and casualty insurance policies. To help you get up to my speed, let’s look at an analogy using something we are all a bit more used to seeing and managing: cars.
If you give me some artistic license here, I might just convince you that the IRS thinks of annuities like cars and that this is a good thing.
Same Difference
First off, let me better define what I mean when I say cars – generally I mean any wheeled vehicle designed to carry passengers on a road. A car can be a luxury SUV like the Lamborghini Urus or something more humble like the VW Touareg, a Nissan 370Z sports car or an Infiniti SUV, or a Dodge Caliber minivan versus a Mitsubishi Evo rally car. Each of these can get you from point A to point B, though different cars will offer different experiences and help you achieve different goals.
The IRS defines an annuity in the broad way that I am defining a car: “a contract that requires regular payments for more than one full year…” The IRS definition of an annuity is important to me because annuities have a specific tax code that applies to them that lets me help clients trade out an annuity that is not working for one that is better suited. Tax planning is an integral part of financial and retirement planning because it directly impacts your total wealth returns, and annuities offer insurance guarantees that cannot be truly replicated in a brokerage account.
When it comes to how the IRS looks at annuities, it is a lot like how car manufacturers look at these sample cars. The pairs of cars I named above were not randomly selected: they each share the same chassis. Yes you read that correctly – each of the examples above are two different cars built on the same foundation but for entirely different purposes. Because annuity policies are so similar in the eyes of the IRS, it should make sense that the IRS allows for like-kind exchange treatment on annuity policies like they allow like-kind exchanges for real estate and other investment property.
The IRS does not care if your annuity policy has a four-liter turbocharged Lamborghini V8 engine or an economical two-liter four cylinder nor will it prevent you from exchanging one for the other if you think your needs and goals are better served by one over another.
Get Yourself in Gear
This IRS approach to exchanging insurance policies provides a great opportunity for investors and retirees to use because in an like-kind exchange the IRS does not allow for any gain or loss to be recognized.
In a like-kind exchange, the policyholder(s) request an annuity from an insurance company – either a new one, or one from which they already have a policy – and instead of payment details, the current annuity is listed for exchange. This instruction is key to the like-kind, 1035 exchange: it means the cash value of the existing policy goes directly to the new company instead of being paid out to the policyholder(s), which would be a taxable event even if they immediately used the funds to purchase a new annuity separately.
The examples below are situations when we strongly consider like-kind exchanges:
If you inherit an annuity held outside of a retirement account, it might not be the best annuity for you. Use a like-kind exchange to move on from your parent’s SUV-style annuity to one that is more exciting for you.
If you previously purchased an annuity with taxable funds and have deferred gains in that contract, execute a complete or partial like-kind exchange to another annuity contract while continuing to defer taxes. This allows you to benefit from tax-deferred compounding while increasing the interest rate of your annuity contract(s).
If you have a life insurance policy but no longer need the cash value benefits and have deferred gains inside the policy, the IRS even allows for like-kind exchange treatment for exchanges from life insurance to annuities.
Talk with an advisor that has the right experience and works as a fiduciary when reviewing insurance policies.
Doug “Buddy” Amis, CFP®
