573 / Is the exchange of one annuity contract for another permissible if the owner-beneficiary inherited the annuity from a deceased original owner?

In general, the original owner of a nonqualified annuity product is able to exchange one annuity for another in an IRC Section 1035 exchange without treating the transaction as a sale—no gain is recognized when the first annuity contract is disposed of, and there is no intervening tax liability. Despite this, Section 1035 requires that, for the annuity exchange to be tax-free, the newly acquired annuity must be payable to the same individual that was entitled to annuity payouts under the original annuity.¹

The IRS has ruled privately that the beneficiary who inherits rights to payouts under an annuity also inherits an ownership interest in the annuity that is sufficient to allow tax-free exchange treatment under IRC Section 1035.²

In the IRS ruling, the beneficiary inherited multiple annuity products and elected to receive distributions over her life expectancy after the original account owner’s death. Later, she found an annuity product that offered more attractive investment features and sought to exchange the original contracts for an annuity that would increase her annuity payout, but would continue to distribute those payouts over her life expectancy.

By allowing this exchange, the IRS permitted the beneficiary to exchange the entire pre-tax value of the inherited annuity, rather than requiring that she take a lump sum distribution of the inherited annuity interest, pay taxes on this distribution and then purchase the replacement annuity contract with the after-tax value.