A classic challenge of beneficiaries of inherited (non-qualified) annuities is that they have been "stuck" with whatever contract was originally owned by the decedent, often locking the beneficiary into a series of investment choices (or lack thereof) that limited the ability of the contract to be invested accordingly to his/her needs and goals, especially when a fixed annuity was inherited by a young beneficiary who wanted to invest for long-term growth. The only alternative: beneficiaries who wanted to reinvest the proceeds were forced to liquidate the contract, paying any/all gains at that time (at ordinary income rates), and then reinvesting whatever was left over.
In a new private letter ruling from the IRS, though, the rules are now changing. PLR 201330016 granted the beneficiary of a series of several fixed and variable non-qualified inherited annuities to complete a 1035 exchange of those contracts into a new variable annuity to gain access to more appealing investment returns. In the IRS' viewpoint, the beneficiary-as-inheritor had sufficient ownership and control of the inherited annuity to allow the exchange, and permitted the exchange to occur, as long as the technical requirements for the 1035 exchange were honored, and the beneficiary committed to taking post-death distributions from the new annuity at least as rapidly as were occurring under the old contract.
While this is ultimately "just" a private letter ruling, and not technically binding, it seems likely the IRS will continue to follow the ruling as long as it is not abused. Accordingly, though insurance companies will need to decide whether they individually will comply, and prepare the appropriate forms and paperwork to ensure that the technical requirements stipulated in PLR 201330016 are honored, the reality is that this new ruling may have finally opened the door for beneficiaries of inherited non-qualified annuities to gain a new level of flexibility to make decisions about what to do with inherited annuity contracts, and exchange accordingly as desired.
Understanding The Facts PLR 201330016
Under Private Letter Ruling 201330016, taxpayer's mother owned a series of (non-qualified) fixed and variable annuities, for which the taxpayer was the beneficiary of the contracts. When the mother passed away, the beneficiary made a timely election to stretch payments over her life expectancy and began distributions accordingly (presumably consistent with the rules under PLR 200151038 allowing "stretch" distributions from inherited IRAs without annuitization).
At some point thereafter, the beneficiary decided that she would like to exchange her inherited annuities to another, new variable annuity contract, which she anticipated would generate a more appealing rate of return on the remaining assets and allow her to generate greater cash flows for herself. Accordingly, the taxpayer completed an application for the new variable annuity, signing at the time of application the forms to elect immediate systematic distributions from the new contract in a manner that would be consistent with the required minimum distributions previously underway with the existing inherited annuities. In addition, the taxpayer completed additional forms that would limit her ability to transfer ownership of the new annuity, and prevent her from making new contributions to the contract, thereby ensuring that only the monies associated with the inherited annuity would be held in the new contract, and that the funds would remain payable only to herself as the (original) beneficiary.
Given these series of steps to ensure that the new variable annuity would be distributed in a manner at least as rapid as the previous inherited annuities, and that all the other "standard" requirements for a 1035 exchange had been met (including signing the appropriate paperwork to have the existing inherited annuities assigned to and remitted directly to the new annuity company), the taxpayer requested that this exchange for existing inherited annuities for a "new inherited annuity" contract be permitted as a Section 1035 tax-deferred exchange.
Current And New World Of Inherited Annuity 1035 Exchanges
Historically, annuity companies have not permitted beneficiaries to complete 1035 exchanges of inherited annuities (at least in the case of non-qualified annuities; for inherited annuities held inside of retirement accounts, post-death transfers were generally permitted under the existing rules for direct transfers of inherited IRAs). For better or for worse, the non-qualified annuity contract that was originally owned was the one the beneficiary was stuck with, as it wasn't clear how the "owner" of an annuity could exchange to a new contract when the (original) owner was deceased. This inability to exchange an annuity contract after the death of the original owner was especially problematic if the beneficiary ended out tied to an annuity company with a weak or declining credit rating. More commonly, it was a challenge simply because the investment choices of the original owner's annuity often didn't align with how the beneficiary wished to invest, especially in circumstances where the beneficiary inherited a fixed annuity but wanted to invest in equities for growth (i.e., wished that he/she had inherited a variable annuity instead).
Yet in parsing through the historical legislative guidance from Congress and subsequent rulings from the IRS on 1035 exchanges, the IRS in PLR 201330016 acknowledged that in reality, the beneficiary of an inherited annuity does effectively become the new owner, that the guidance on how to complete a 1035 exchange can be applied accordingly (as long as the ownership doesn't change, and the funds are transferred directly from the old company to the new company), and as a result that a 1035 exchange should be permissible.
The key point of emphasis in the IRS' ruling was simply that the terms of the new contract must ensure that distributions will continue in compliance with IRC Section 72(s)(1), which stipulates the rules for required minimum distributions over the life expectancy of the beneficiary (or subject to the 5-year rule) after death of the original owner. In other words, as long as the 1035 exchange by the beneficiary isn't done in a manner to circumvent the post-death distribution rules, and is simply a change of contract and investments with the same (beneficiary) owner maintained, that the exchange of the inherited annuity is permissible.
Financial Planning Implications
PLR 201330016 represents the first time the IRS has directly tackled the issue of 1035 exchanges of non-qualified inherited annuities by a beneficiary, and provides rather straightforward guidance about how such exchanges can be accomplished in the future: just be certain that the new contract provides that distributions will occur at least as rapidly as they were scheduled to occur under the original inherited contract. As long as that requirement is met, and the other standard rules for 1035 exchanges are followed, beneficiaries should be able to make exchanges to new annuity contracts that better fit their individual needs and circumstances.
This ruling will be a relief for inherited annuity beneficiaries who have been "stuck" with the original owner's type of annuity, and consequently have had their investment choices restricted, especially for non-spouse beneficiaries (as spouses could "roll over" and continue the contract in their own name under IRC Section 72(s)(3)). While variable annuities generally provide a wide range of investment options, which meant a beneficiary could simply change the selected subaccounts to alter the investments of the contract (e.g., by reallocating amongst the available bond, equity, and other investment choices), in scenarios where the original annuity was a fixed annuity there were no investment choices on the table. As a result, beneficiaries of inherited fixed annuities couldn't reallocate to invest for growth even if they wanted to. Beneficiaries of equity-indexed annuities were similarly restricted to only the equity-indexing formulas available under that particular annuity contract, and not the wider range of investment choices that might be available in other contracts.
Yet with the new PLR 201330016, these limitations are off the table; instead, the beneficiary who is unhappy with the inherited annuity contract can simply exchange to a new one with more desired investment choices based on his/her needs and goals. Similarly, those who wished to make changes to inherited annuities for other reasons - perhaps the expenses of the annuity were uncomfortably high for the value being provided, or the rating of the insurance company was uncomfortably low (or worse, declining) - now have the flexibility to do so. And given that the ruling allowed both the exchange of fixed and variable annuities into a new variable annuity - without otherwise expressing any concern or issue over the matter - the IRS appears, consistent with other annuity rulings, to be open to any annuity-to-annuity exchange, as long as it meets the appropriate requirements, regardless of the "type" of annuity.
On the other hand, the biggest caveat of this ruling is that an exchange of an inherited annuity can only occur if the contract actually provides for such liquidity in the first place. If an inherited annuity contract has been annuitized - such that there is no cash value to exchange in the first place - it does not appear possible for a post-death exchange to occur. Similarly, if the inherited annuity otherwise limits payouts - for instance, some contracts require that the beneficiary take money out over a minimum of 5 years and not as a liquid lump sum - a post-death 1035 exchange does not appear possible. A restricted beneficiary designation form that constrained payments to beneficiaries (e.g., limiting beneficiaries to only access the annual required minimum distribution and not the entire amount) would also appear to prevent a postmortem 1035 exchange by the beneficiary. Overall, the bottom line is that beneficiary can only sustain the original required distributions in a newly exchanged annuity contract if the money is liquid enough to be extracted from the "old" annuity and transferred directly to the new company in the first place, or the strategy is a moot point. On the other hand, if the beneficiary intends to just liquidate the contract anyway, the strategy is also moot; completing a 1035 exchange by the beneficiary to a new annuity to continue (only) post-death required minimum distributions presumes that the beneficiary wants to stretch to begin with (though even if exchanging to a new stretch contracts, there's nothing to prevent a beneficiary from starting out taking the minimum payments and then increasing withdrawals later, as the rules require only that a minimum amount to be withdrawn).
It's also notable that if a beneficiary is considering a 1035 exchange of an inherited annuity, now that such transfers are permitted under the private letter ruling, due diligence on the exchange is still crucial. This may include an in-depth evaluation of the investment merits of the original inherited annuity (including lesser-reviewed provisions like the minimum return guarantees of the fixed account or the minimum annuitization rates of the contract) and the costs of the contract, along with the costs and benefits of the new contract being considered. Given that withdrawals will be required in the first year from the new contract - to continue the IRC Section 72(s) post-death distribution requirements - it's also important to verify that those withdrawals will not run afoul of any new surrender charges of the new contract, or result in the immediate forfeiture of any gains (e.g., in the case of some equity-indexed annuities with a long point-to-point period that don't lock in gains for intra-year withdrawals).
Of course, in the end, it's also crucial to bear in mind that ultimately a private letter ruling applies only to the individual who applied for the ruling; technically, the IRS is not bound to follow this ruling, and its prescriptions for postmortem 1035 exchanges of inherited annuities by beneficiaries are certainly not required to be followed by today's annuity companies. Nonetheless, there's little reason to expect that the IRS would not continue to follow the ruling, at least for exchanges that occur within the faith and intent of the rules (a properly executed 1035 exchange where the new contract continues to make distributions at least as rapidly as the prior contract). Companies that wish to honor the guidance in the ruling will likely establish "standard" inherited annuity 1035 exchange forms that conform to the requirements acknowledged in the PLR (including contractual provisions that annuity ownership cannot be transferred, that new contributions cannot be made, and that distributions must occur at least as rapidly as prescribed under IRC Section 72(s) for the original decedent's annuity contract).
The bottom line, though, is simply this: for beneficiaries of inherited annuities who were unhappy with the annuity contracts and companies to which they were tied - because it's what the decedent owned when he/she passed away - a new world of flexibility looks to be opening up for those who follow the 1035 exchange guidance.
For further reading on private letter ruling 201330016, see here for the original ruling on the IRS website. And for those looking for additional objective information regarding the technical rules and taxation of annuities in general, check out my book "The Advisor's Guide To Annuities" as well!