Weinstock emphasizes that 1035 exchanges may have significant costs and disadvantages. For instance, an annuity may incur a steep surrender fee if exchanged before the end of the surrender period, which typically lasts several years after purchase. "It should be approached with caution always, in my view," Weinstock says.
Steve Azoury, a broker in Troy, Mich. who specializes in annuities, says one common 1035 exchange involves a fixed annuity purchased several years ago when it paid 5% but pays only 1% now. A variable-rate annuity could pay more, Azoury says, but if the existing fixed annuity has grown in value, the gain would be taxed when the annuity is simply cashed out and proceeds used to buy a new annuity.
Another example is someone who has a life insurance policy paying a death benefit to a spouse. If the spouse who is the intended beneficiary dies first, it may save on taxes to do a 1035 exchange into an annuity rather than cash out the life policy and invest the proceeds elsewhere.
Fees represent the major concern. In addition to surrender fees, variable annuities in particular may incur ongoing fees that cut steeply into future investment returns.
Annuity sellers earn commissions of up to 10% of purchase price, with variable annuities paying the highest commissions and fixed annuities paying the lowest. Annuity commissions can be significantly higher than other investment products. And purchasers ultimately pay commissions through reduced returns.
When a 1035 exchange isn't too costly, provides the return, features a buyer needs and offers a meaningful tax benefit, it can make sense. "If a person is happy with their account, they're happy," Azoury says. "If they want to go to a different account, they can do that and not be held hostage by taxable gain."