Have Lower-Yielding or Underperforming Annuities or CDs?

By Ken Nuss

Today’s higher interest rates are great when you have new money to invest. But what can you do if your money is already tied up in lower-yielding deposit accounts—specifically, bank certificates of deposit and/or fixed-rate annuities that are still subject to early surrender penalties?

It turns out you do have options, especially with annuities.

While CDs have penalties for early termination, they usually let you withdraw accumulated interest penalty-free. You can use that interest to buy another higher-paying CD, or better yet, a higher-yielding annuity, as long as you don’t plan to withdraw any money from it before age 59½.

Sometimes it’s worth terminating entirely and paying the penalty. You just have to do the math to make sure it’s a good move.

A fixed-rate deferred annuity (also called a multi-year guarantee annuity or MYGA) acts a lot like a bank certificate of deposit because it pays a guaranteed rate of interest for a set term. They’re typically more liquid, though.  Most of these annuities let you withdraw up to 10% of the contract value annually, penalty-free. (If you take out more than 10% during the penalty period, the insurer will levy a penalty.)

This provides valuable flexibility. Penalty-free withdrawals let you transfer funds from an older low-yielding fixed annuity (or from an underperforming fixed-indexed annuity or a variable annuity) into an annuity that guarantees a higher interest rate for years.

Exchanges and transfers are tax-free

To avoid taxes, with a nonqualified annuity (one that’s not in an IRA), you must use a partial exchange to purchase your new annuity. Under a partial so-called “1035 exchange,” funds pass directly from the old insurer to the new one. A competent annuity agent can arrange for such an exchange.

With an IRA annuity, a direct transfer between insurance companies is tax-free.

How Bob gets more Interest

Bob, a retiree, has three fixed-rate annuities paying 2.50%, 2.85%, and 3.05% respectively, plus a high-fee underperforming variable annuity. All four are nonqualified annuities still subject to early-surrender penalties, so it wouldn’t make sense for Bob to surrender them entirely. Instead, he takes 10% partial exchanges from each of the fixed-rate annuities to a new seven-year annuity that pays 4.50%.

With the vast majority of annuities, you must use the partial withdrawal that year or lose it. A few allow you to carry over the 10% from one year to the next for a cumulative withdrawal. His variable annuity has that feature, so he can transfer 30% of the contract value penalty-free to the new annuity. He decided to move money out of the variable product because he wants to lower his risk and get today’s higher guaranteed annuity rates.

The fact that he can now get up to 4.50%—versus about 3.20% for a seven-year contract in late 2021—changed his calculus.

Partial 1035 exchanges—take care

A special IRS rule applies when using nonqualified funds in a partial 1035 exchange. If any withdrawals are made from either contract within 180 days of a partial exchange, the exchange is invalidated and becomes a taxable event.

Also be aware that if you withdraw money from your nonqualified annuity before age 59½, you’ll typically owe the IRS a 10% penalty on the accumulated interest earnings you’ve withdrawn (unless you’re permanently disabled) as well as ordinary income tax on the amount. Therefore, don’t buy a deferred annuity unless you’re sure they won’t need the money from it before 59½.

As mentioned, a 1035 exchange avoids this problem because it’s not considered a withdrawal by the IRS.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com  or by calling (800) 239-0356.