Written by Jonathan Vance, CFP®, EA
I do not sell annuity contracts or earn any compensation from the sales of financial products. However, I do advise clients on their full financial picture, which can include evaluating annuities.
If you don’t have an annuity at all, you may want to skip this blog post since it’s written from the lens of someone who does. You are, of course, welcome to read on for education’s sake if you’d like.
Whether you’re reading because you already own an annuity contract or reading simply for education’s sake, I hope you find the next few pages helpful.
Whether you purchased an annuity to meet a specific goal or ended up with one after attending a steak dinner seminar, it’s important to know: you have options.
The funds within your contract aren’t locked away without recourse.
If the steak dinner reference made you chuckle or cringe, you’re not alone. Annuities have earned a controversial reputation over time, and for good reason.
Here’s why:
This mix of complexity, limited product scope, and potential for lucrative payouts has led to some questionable annuity contract sales practices over the years.
All of that to say, I felt that my disclaimer right out of the gate might prevent you from mentally blacklisting me just for mentioning the “A word.”
Now that we’ve cleared the air, let’s walk through how you might analyze an existing annuity contract to see if you should consider a 1035 exchange.
Before deciding whether to exchange your annuity, keep it as-is, or take a lump-sum withdrawal, consider these four key questions:
We’ll walk through each of these steps in the remainder of this post.
Annuity costs typically fall into three primary categories:
For variable annuities:
For fixed or fixed indexed annuities:
Riders, which are available on a broad range of annuity contracts, add costs for features like:
Rider fees typically add 0.50% to 1.50% expenses each. Altogether, total annual costs often range from 1% to 3% of the contract value, or $5,000 to $15,000 per year on a $500,000 annuity.
That doesn’t automatically make it a bad deal. If the contract offers valuable protections you can’t get elsewhere, it may still be worth keeping. But understanding the costs helps you compare it to other options.
If your annuity is cost-effective and provides meaningful guarantees that you value, you might decide to keep it and stop your 1035 exchange analysis here.
But if you decide that you own an expensive annuity and you aren’t sure whether or not you need the income guarantees, read on.
This is partly subjective, but I would argue that there are objective scenarios where guarantees aren’t necessary.
For example:
This scenario is more common in lower cost of living areas like Southwest Missouri, where I’m located. According to the Missouri Economic Research and Information Center (MERIC), our cost of living in the Springfield area ranks roughly 10% to 12% below the national average. Because of this, a local retired couple's combined Social Security benefits may cover a surprisingly large portion of their everyday living expenses.
In addition to guaranteed income sources, many retirees rely on savings (like 401(k)s, IRAs, and other investments) to supplement income, which introduces risk. Whether you want to guarantee a portion of that income depends on your comfort level and goals.
In my opinion, the best way to approach your comfort level of income guarantees or lack thereof is to look at scenarios in financial planning software and have genuine conversations with your family and/or trusted advisors.
Important Caveat: Be cautious about who you take advice from when it comes to income guarantees. As I often mention, financial conflicts of interest can lead to advice that isn’t necessarily unbiased. For example:
If you decide that you value (in your unique definition of the word “value") the income guarantees that you already have, you may wish to stop your 1035 exchange analysis here and elect to keep your annuity as is.
Or, you may still shop around to see what other annuity carriers are offering in terms of income guarantees to see if you can find an even better “bang for your buck”.
But if you have decided that you do not value the income guarantees, read on to the next portion.
By this point in your annuity analysis, you may be leaning towards unwinding the policy. Before you do, it’s crucial to understand the tax treatment of doing so.
For a more comprehensive overview on annuity taxation, I would encourage reading through IRS Publication 575. But here are a few high-level considerations:
For IRA or Roth IRA annuities:
For non-qualified contracts (without annuitizing):
This requires some individual tax planning. In some cases, realizing all of the gain in a lump-sum may be appropriate. In others, you may wish to take withdrawals from the policy over a few different tax years to minimize the burden.
Or, you may even decide that it’s in your best interest to avoid triggering taxes for several years but are still looking to eliminate excess costs. This route may further lead you down the road of a 1035 exchange.
You have plenty of options. Here’s an example of an investment only variable annuity (IOVA) that may be an appropriate substitute for an old annuity for someone who wants to keep their annuity “tax wrapper” while eliminating unwanted riders and lowering investment costs:
If you’ve followed the decision tree to this point, the next step is initiating the 1035 exchange.
Even if a 1035 exchange makes perfect sense from a cost, guarantee, and tax perspective, there is one final hurdle you should check: the surrender charge.
Think of a surrender charge as a sliding-scale penalty for breaking your contract early. Because insurance companies often pay upfront commissions to the salespeople who sell these products, they protect themselves by locking your funds into a "surrender charge schedule." If you pull your money out or exchange the contract before this schedule clears, the insurance company might deduct a percentage of your contract value. While every annuity contract is unique, a typical surrender schedule might be around a 7% penalty in the first year and steps down by 1% each year until it hits 0% by year eight.
Before pulling the trigger on an exchange, call your current annuity carrier to make sure you understand any surrender charges that may apply.
If you’ve navigated the costs, evaluated the guarantees, mapped out the taxes, and verified that the surrender charges won’t derail your progress, you are finally ready to initiate the 1035 exchange.
Annuities are complex financial instruments, plain and simple. Any time you add complexity, you can find people on either side of the aisle claiming that the added complexity was “great” or “horrible”. The reason for their answer almost certainly lies in the context of their unique situation and experience.
You may gravitate more toward or against annuities for a number of reasons, and that’s just fine. However, for those who already own an annuity product, I always recommend doing due diligence on your options.
If you find your existing contract already works great and there’s no room for improvement, at least you have the peace of mind that you checked. If you find significantly better options out there, your future self might just say “thank you” for taking the time.
And if you need help sorting through the details, consider partnering with a fee-only CFP® Professional (who cannot accept commissions for annuity sales) to discuss your options without the added sales pressure. As of the date of this blog post, Vance Financial Planning is currently taking on new clients if you’d like to learn more about our pricing and process, or you can check out NAPFA’s Find An Advisor if I’m not a good fit.
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