1035 Exchange Question

Submitted by Steve Hagedorn on Wed, 2019-08-14 15:40

I wonder if it is possible to fund my employee 401K plan I have through work (employer’s plan) by making yearly contributions funded by executing a 1035 exchange from an individual taxable annuity I presently have.

The taxable annuity has a present value of $200K of which $170K is principle (I funded the annuity with after tax dollars).

Since I am not at least 59.5 years old, taking withdrawal from the annuity to fund my 401K would incur an IRS early withdrawal tax penalty (10%) which I am trying to avoid. I will not be 59.5 for another 6 years.

Both plans offer a similar investment (the same Vanguard mutual fund in the annuity as in the 401K plan) so if yearly partial exchanges were possible ($25K/ year) from the annuity into the 401K plan I would attempt to make yearly exchanges “in kind”.

Thanks in advance for your help.



Submitted by Alan - IRA critic on Wed, 2019-08-14 17:52

No, that is not possible. 401k contributions much be in cash from taxable compensation including after tax non Roth contributions as well as the usual elective deferrals. You would have to take an annuity distribution and use it to allow you to afford to max out your 401k including after tax contributions if your 401k offers them.

Submitted by Robert Vashko on Sat, 2019-08-17 00:57

A 1035 exchange is meant for tax-free transfers to/from insurance policies, endowments and non-qualified annuities.  You cannot 1035 any of these into a qualified account like a 401(k).The 10% penalty only applies to the deferred gain on the NQ annuity – in your case, $30,000.  So, if you wanted to take out $25k every year, your first withdrawal would come out of the gains first.  Meaning, that first withdrawal would have a 10% penalty of $2,500 on it.  This is in addition to the ordinary income tax you will pay on the distribution.Your second $25k distribution (assuming no market gain/loss) would include the remaining $5,000 of gain.  The other $20,000 of this second distribution (and all future distributions) would come out of the $170k of principal (after-tax money), meaning no 10% penalty and no income tax either.

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