Should I exchange my variable annuity?

Steve Merrell |

Q: Several years ago, I went to roll over a CD at my bank. While I was there, the gentleman suggested I talk with the bank’s investment expert to see what other options were available. In the end, I decided to put my money in a variable annuity. It seems to have done okay (I don’t really know), but the bank recently contacted me about exchanging my old annuity for a better one. Does an exchange make sense?

A: It is pretty common for bank investment officers to push variable annuities. Variable annuities are often designed to appeal to inexperienced investors, especially those with low risk tolerances, so owners of bank CDs are prime targets. Brokers love to sell them because they earn juicy commissions—sometimes as high as 8 percent. Insurance companies love them because they earn higher fees on variable annuities than most other products.

Unfortunately, I find that most people who own variable annuities don’t really understand what they have. Variable annuities can be very complex and the fees are not always transparent. If you are invested in a variable annuity, or are considering such an investment, you might want to track down a little booklet published by the Securities and Exchange Commission called, “Variable annuities: What you should know.” It is only about 20 pages long, but it is chock full of important information. You can google it and download it directly from the SEC’s website.

One of the primary benefits of variable annuities is tax deferral. Much like an IRA, the money you invest in a variable annuity grows tax-free as long as it stays in the variable annuity. However, as soon as you take money out of the variable annuity, the IRS expects you to pay ordinary income tax on any growth in the value of your investment.

Section 1035 of the Internal Revenue Code provides a way for investors to exchange insurance contracts (including variable annuities) without triggering a tax event. However, be very careful when you make the exchange. The rules are specific and must be followed closely. For example, you have to actually exchange contracts. If you cash out your variable annuity and apply the proceeds to a new annuity, it will count as a taxable withdrawal from the original annuity. Also, an annuity can only be exchanged for another annuity. If you exchange an annuity for a different type of insurance contract, you will end up with a taxable transaction.

There are several reasons why a 1035 exchange might look attractive. For example, insurance companies sometimes offer “bonus credits” of between 1 and 5 percent. Let’s suppose your old annuity is worth $100,000 and you exchange it for a new annuity with a bonus credit of 3 percent. Just by doing the exchange, your new annuity would earn an additional $3,000.

Another reason could be the availability of new features, including features that provide increased protection from market risk. These features can be quite complex and are not always as they seem, so take time to thoroughly understand them. The broker who is proposing the exchange should be able to explain everything clearly. If he can’t, do not make the exchange.

When you consider an exchange, take a careful look at all aspects of the exchange, comparing the annuities’ fees as well as features. Sometimes the fees of the new annuity outweigh the anticipated benefits and even a generous bonus credit can be quickly offset by higher administrative costs. Also, look carefully at any new surrender charges the new annuity may impose on you. Most annuities charge hefty penalties if you choose to surrender the contract within the first few years.

There is one exchange I have little problem recommending. In recent years, a number of low-cost variable annuities have been created allowing investors to cut their annual fees dramatically while retaining the benefits of tax-deferral. If you are already invested in a variable annuity, ask your financial advisor to show you some low-cost 1035 exchange options. Tax-deferred savings with low fees sounds like a winning combination to me.



Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to