The decision to purchase a particular annuity is based on several factors including an investor’s financial circumstances as well as the features present in the product that, at the time, closely matched the investor’s needs and preferences. As time passes, financial circumstances can change and an annuity’s features may no longer be the match they once were. Or, perhaps the annuity is no longer performing as expected. There could be any number of reasons why someone would want to change their investment, and annuity contracts do allow for such changes, however, a “rollover” from one annuity to another annuity is not one of them.

What is a Rollover?

It is possible, however, to change from one annuity to another, but that process is referred to as a direct transfer which is described below. First, let’s take a step back and define “rollover” so that the difference is clear. A rollover, as described in the tax code, is when the holder of a qualified plan such as an IRA takes a complete, physical distribution from the plan, and then rolls it or deposits it into another IRA. The rollover must occur within 60 days of the distribution in order to avoid a tax consequence.

Annuities are non-qualified plans which aren’t covered under the rollover rules. If a full distribution is taken from an annuity it requires that the annuity contract be surrendered which automatically triggers a taxable event. The amount of the distribution that is comprised of earnings from the contract will need to be reported as ordinary income and taxed in the year of the distribution.

If annuity is purchased inside of a qualified plan, then technically, the distribution, or surrendered funds, can be rolled over to another qualified plan and another annuity can be purchased inside that plan. And, it is possible to roll a qualified plan distribution into an annuity as long as the annuity is set up by the life insurance company as an IRA annuity. The bottom-line is that a tax-free rollover can only occur between two tax-qualified accounts.

If not a Rollover, then What?

Annuity owners are allowed to change their annuity investment through what is known as a direct transfer which is allowed under IRC. Section 1035. Also known as a 1035 Exchange, the direct transfer is facilitated by the current annuity provider and the new annuity provider, so the annuity owner never touches the funds. This is the only way that the transfer can occur without a tax consequence.

In order for the transfer to occur, the first annuity has to be surrendered. That means that, if it occurs during the contract’s surrender period, a surrender fee will apply. If the surrender period has expired, then the funds can be transferred without charge. And that is one of the main caveats of a tax-free 1035 exchange of annuities, and that is when a new annuity is purchased, the surrender period begins anew.

Exchange with Care

If you have made the decision to exchange your annuity, great care should be taken to ensure that you will be improving your situation. Obviously, the new annuity should be fully vetted for a complete understanding of its fees, expenses and surrender provisions. Understanding that you will be purchasing a new annuity with a fresh surrender period, it is important to have a long term time horizon in your thinking. You may be able to find an annuity with a shorter surrender period, but be aware that it may have higher internal expenses as an offset.

Also, once you have made the exchange decision, and have selected a new annuity, you could be at risk if the exchange process is delayed at either end. For instance, you may have selected an annuity based on its high promotional rate. If the exchange process takes too long, it is possible that the promotional rate on the new annuity is no longer available when the funds are finally received by the new provider. Although annuity providers are required to begin processing an exchange as soon as they receive the request, they have been known to take the as much time as they are allowed in order to keep your money working for them as long as possible. So, it is possible to miss a promotional rate or a significant move in the market (if you’re exchanging to a variable contract).

The same care taken with your initial annuity investment should be taken with the exchange into another annuity product. The new annuity product should be a solid match for your investment objectives, timeline, preferences and risk tolerance. When done properly, an annuity exchange should put you in a better financial position than before the exchange.