Non-Quaified Index Annuity – 1035 Exchange
In December my client discovered an index annuity ($156K) which she was unaware of for almost 9 years. She wanted to move her funds from this insurance company immediately because of a negative experience with them a few years ago.
The index annuity was in the final year with a minimal surrender fee. My client also wanted to withdraw under $10K for her own needs and reinvest the balance with a different annuity and company
She surrendered the policy and received a check for approximately $156K. As soon as the funds cleared (10 days, my client sent a check for $148K to a new insurance company for an index annuity with better features and benefits. Both annuities were and are in her name.
My client’s CPA is telling her the entire gain on the original annuity ($56K) is fully taxable now, because the transaction was not done directly between the two insurance companies as an “Official 1035 exchange.” (The initial deposit or cost basis was $100K)
The intention of the transaction should fall within the “spirit” of the 1035 Exchange Rule as one index annuity was exchanged for a similar and better index annuity with another company. $148K of the funds were immediately transferred to the new insurance company within 2 weeks..
I am looking for a precedent or support for this transaction to be considered a 1035 Exchange and the small withdrawal taken ($10K) to be taxed as a gain.
Any help or recommendation is greatly appreciated.
Permalink Submitted by Alan - IRA critic on Fri, 2015-03-13 18:50
I have not heard of any exceptions to the direct exchange requirements, so the CPA is correct unless there is a letter ruling I am unaware of. The 1099R reporting the distribution will not include the Box 7 Code 6 denoting an exchange and the IRS will consider this a taxable distribution of which 56k is taxable and subject to penalty barring a penalty exception such as being 59.5.
Permalink Submitted by Lee Paper on Fri, 2015-03-13 19:09
The 1099R Box 7 Distribution Code says 7D. In this case my client is 67 years old.
Permalink Submitted by Alan - IRA critic on Fri, 2015-03-13 19:31
Coding is correct for a taxable distribution. No penalty due to age, but I imagine that Box 2a shows the taxable amount. Note that this is not an extra tax, it just moves a future tax on the gains into the current year.