Annuity Replacement Guide

Annuity contracts are long-term financial commitments, and the decision to replace one should never be taken lightly. However, the annuity marketplace evolves continuously, and contracts that were competitive when you purchased them may no longer offer the best value compared to what is available today.

There are legitimate reasons to consider replacing an existing annuity, such as accessing better interest rates, lower fees, improved features, or a contract structure that better aligns with your current retirement goals. At the same time, there are situations where keeping your existing contract is the wiser choice, particularly if surrender charges are still in effect or if your current contract offers benefits that would be difficult to replicate.

The key is to approach the decision with a thorough, side-by-side comparison of your current contract versus the proposed replacement. This guide will walk you through the critical factors to evaluate.

A 1035 Exchange is a provision in the U.S. tax code (IRS Section 1035) that allows you to transfer funds from one annuity contract to another without triggering a taxable event. Named after the section of the Internal Revenue Code that authorizes it, a 1035 exchange is the most common method for replacing an existing annuity.

How a 1035 Exchange Works

1. You apply for the new annuity contract — Work with a qualified advisor to select a new annuity that better meets your needs. The application will specify that the funding source is a 1035 exchange from your existing contract.
2. Paperwork is submitted to the existing insurance company — The new insurance company sends a transfer request to your current carrier. This initiates the exchange process.
3. Funds are transferred directly — The money moves directly from the old insurance company to the new one. The funds never pass through your hands, which is what preserves the tax-deferred status. This is a critical requirement for a valid 1035 exchange.
4. The new contract is issued — Once the new insurance company receives the funds, your new annuity is established. Your cost basis (the amount you originally invested) carries over to the new contract.

Eligibility for a 1035 Exchange

A 1035 exchange can be used in the following scenarios:

• Annuity to annuity (the most common use case)
• Life insurance policy to annuity
• Life insurance policy to life insurance policy
• Annuity to a qualified long-term care insurance contract

Note that you cannot exchange an annuity for a life insurance policy. The exchange must follow specific IRS rules, so working with an experienced advisor is important to ensure the transaction is handled correctly.

Not every annuity needs to be replaced, but the following warning signs indicate that your current contract deserves a closer look:

High Fees Eating Into Returns

If your annuity carries annual fees of 2% to 3% or more (common with older variable annuities), those costs can significantly reduce your net returns over time. For example, a 2.5% annual fee on a $200,000 annuity costs you $5,000 per year regardless of performance. Newer products, particularly fixed indexed annuities, often have substantially lower fee structures.

Poor Performance vs. Expectations

If your annuity has consistently underperformed relative to what you were told to expect, or if the credited interest rates have dropped well below competitive levels, it may be time to explore alternatives. This is especially common with older variable annuities where sub-account performance has been disappointing, or with fixed annuities that were competitive years ago but now offer below-market rates.

Surrender Period Restrictions

If you are locked into a long Surrender Period with high charges, you may feel trapped in a product that no longer serves you well. While you generally want to wait until the surrender period ends before replacing, some situations may justify paying the surrender charge if the long-term benefits of the new contract outweigh the short-term cost.

Limited Investment Options

Older variable annuity contracts may have a limited selection of sub-accounts that no longer meet your investment preferences. Similarly, older fixed indexed annuities may not offer the range of index options and crediting methods available in today's products.

Outdated Contract Features

The annuity industry has evolved significantly over the past decade. If your contract was issued 10 or more years ago, it may lack features that are now standard, such as guaranteed lifetime income riders, enhanced death benefits, nursing home or terminal illness waivers, or flexible withdrawal provisions. Newer contracts often provide more comprehensive benefits at competitive costs.

A replacement is most likely beneficial when one or more of the following conditions are met:

• Better rates are available — If your current annuity offers a low credited interest rate or unfavorable caps and participation rates, a newer product may provide meaningfully better returns. Compare not just the current rates, but also the insurance company's track record for maintaining competitive rates over time.
• You need different features — Perhaps your current contract lacks an income rider and you are now approaching retirement and need guaranteed income. Or perhaps your existing death benefit is minimal and you want stronger protection for your beneficiaries. Replacing with a contract that includes the features you actually need can be a smart move.
• Lower fees are available — If you can move from a high-fee variable annuity to a lower-cost fixed indexed annuity with comparable or better features, the fee savings alone can justify the exchange. Over a 15 to 20 year retirement, reducing annual fees by even 1% can result in tens of thousands of dollars in additional savings.
• Your current contract has ended its surrender period — Once the surrender period has expired, there is no financial penalty for moving to a new contract. This is often the ideal time to evaluate whether a newer product better serves your current needs and goals.
• You want to consolidate multiple annuities — If you own several annuity contracts from different carriers, consolidating into a single, well-structured contract can simplify your financial life and may provide better overall terms.

Understanding the tax consequences of an annuity replacement is essential for making an informed decision.

1035 Exchange: Tax-Free Transfer

When properly executed, a 1035 exchange allows you to move funds from one annuity to another without incurring any immediate tax liability. The accumulated gains in your old contract continue to be tax-deferred in the new contract, and your original cost basis carries over. This is the preferred method for replacing an annuity whenever possible.

Cash Surrender: Potential Tax Hit

If you surrender your annuity for cash instead of using a 1035 exchange, any gains above your original investment (cost basis) will be taxed as ordinary income in the year you receive the funds. This can result in a significant tax bill, especially if your annuity has grown substantially.

Early Withdrawal Penalty

If you are under age 59 and a half and take a cash surrender (not a 1035 Exchange), you may also be subject to a 10% early withdrawal penalty from the IRS in addition to the income taxes on gains. A 1035 exchange avoids this penalty because the funds remain in a tax-deferred annuity structure.

Required Minimum Distributions (RMDs)

If your annuity was funded with pre-tax dollars (such as from a traditional IRA or 401(k) rollover), required minimum distributions may apply once you reach the applicable age. These rules carry over to a replacement contract. If your annuity was funded with after-tax dollars (non-qualified), RMDs do not apply. Understanding how your annuity is classified is important for proper tax planning.

Before committing to an annuity replacement, follow these steps to ensure you are making a well-informed decision:

1. Review your current contract thoroughly

   Request a current statement and review the key details: current account value, surrender value (after any charges), credited interest rate, surrender schedule, death benefit, and any attached riders. Understanding exactly what you have is the essential first step.

2. Compare features side by side

   Create a detailed comparison of your current contract versus the proposed replacement. Look at interest rates, caps, participation rates, fees, surrender periods, income rider terms, death benefits, and withdrawal provisions. Every feature should be compared, not just the headline interest rate.

3. Understand surrender charges on your current contract

   If your current annuity is still within the surrender period, calculate the exact cost of the surrender charge you would pay. Weigh this cost against the long-term benefits of the new contract. In some cases, paying a small surrender charge for a significantly better product can still be a net positive.

4. Evaluate the new surrender period

   A replacement means starting a new surrender period. Make sure you are comfortable with the length of the new surrender schedule, and that it aligns with your timeline for needing access to the funds.

5. Check the insurance company's financial strength

   Annuity guarantees are only as strong as the insurance company behind them. Check the financial strength ratings from agencies like A.M. Best, Standard & Poor's, Moody's, and Fitch before committing to a new contract.

6. Consult with a qualified advisor

   An experienced annuity specialist can help you navigate the comparison process, ensure the 1035 exchange is handled properly, and identify any factors you may have overlooked. A good advisor will present a balanced analysis rather than pushing you toward a replacement.