72(t) Not Allowed After 1035 Exchanges

[Drifting]

I was always told that if there's an existing 72(t) or (q) distribution going on... DON'T TOUCH IT! I guess this is just one example of what can happen if you do interrupt it.

Is that because you then have to pay taxes on PAST withdrawals only? What about setting up a NEW 72(q)? Would that be allowed.

With Vanguard's drastically lower fees, in one year I will be saving more than the taxes I would pay for the prior 3 years of withdrawals. So if I can just start a NEW 72(q) with Vanguard it would be a no-brainer to switch to Vanguard. I will be saving about 2.2% per year.

 

[Tahoe Ray]

Is that because you then have to pay taxes on PAST withdrawals only? What about setting up a NEW 72(q)? Would that be allowed.

With Vanguard's drastically lower fees, in one year I will be saving more than the taxes I would pay for the prior 3 years of withdrawals. So if I can just start a NEW 72(q) with Vanguard it would be a no-brainer to switch to Vanguard. I will be saving about 2.2% per year.

Regardless of the company or the fees, if you take withdrawals from a non-qual annuity that has gains, you'll owe ordinary income taxes. If you're under 59 1/2 and don't qualify for an exception, you'll pay a 10% penalty on the withdrawn gains.

Only you (or someone with direct knowledge of your situation) can do the math to determine if paying the penalty on your previous withdrawals is worth the 2.2% that you would save on your principal annually.

I'm also not taking into consideration any living/death riders that you might have on either contract...that must be taken into account as well.

You pay taxes either way (assuming a gain in your contract). The 72(q) is set up to avoid the 10% early withdrawal penalty on your gains...

 

[Drifting]

Regardless of the company or the fees, if you take withdrawals from a non-qual annuity that has gains, you'll owe ordinary income taxes. If you're under 59 1/2 and don't qualify for an exception, you'll pay a 10% penalty on the withdrawn gains.

Only you (or someone with direct knowledge of your situation) can do the math to determine if paying the penalty on your previous withdrawals is worth the 2.2% that you would save on your principal annually.

I'm also not taking into consideration any living/death riders that you might have on either contract...that must be taken into account as well.

You pay taxes either way (assuming a gain in your contract). The 72(q) is set up to avoid the 10% early withdrawal penalty on your gains...

The Sun America annuity had gains for sure. I was duped into investing in it 20 years ago. I don't care about riders. No need for them.
My question is do any of you think that I will be able to set up a NEW 72(q) program with Vanguard? In other words will I qualify now that I have switched (1035) to Vanguard and now already technically broken one 72(q) program (with Sun America)? Paying taxes on the 3 years of withdrawals is not that big of a deal. That will be made up for in the first year due to Vanguard's lower fees. I'm more worried about getting future payments without incurring a 10% penalty.

 

[Tahoe Ray]

The Sun America annuity had gains for sure. I was duped into investing in it 20 years ago. I don't care about riders. No need for them.
My question is do any of you think that I will be able to set up a NEW 72(q) program with Vanguard? In other words will I qualify now that I have switched (1035) to Vanguard and now broken one 72(q) program (with Sun America)? Paying taxes on the 3 years of withdrawals is not that big of a deal. That will be made up for in the first year due to Vanguard's lower fees. I'm more worried about getting future payments without incurring a 10% penalty.

If you did this 20 years ago, then your riders might not be attractive anyway so I can see your point. A lot has changed in that world by the way...

Anyway, if you are o.k. with just paying the penalties and moving on, just set up a new 72(q) and call it a day. Again, you're paying taxes either way, with the 72(q), you avoid a 10% penalty. Without it, you owe it.

I would still say talk to an accountant, they might be able to save you a few bucks.

 

[Drifting]

If you did this 20 years ago, then your riders might not be attractive anyway so I can see your point. A lot has changed in that world by the way...

Anyway, if you are o.k. with just paying the penalties and moving on, just set up a new 72(q) and call it a day. Again, you're paying taxes either way, with the 72(q), you avoid a 10% penalty. Without it, you owe it.

I would still say talk to an accountant, they might be able to save you a few bucks.

Thanks Tahoe! I left messages for a couple of accountants. Hopefully one calls me back on Monday! I will sleep better if I can set up a new 72(q).

I know that I have to pay ordinary income tax on gains eventually. With annuities you need to TIGHTLY CONTROL the distribution phase otherwise the ordinary income tax rate spirals out of control. That's why I like the 72(q) program. By the time I turn 59 1/2 I've already got one foot out the door from the previous systemic withdrawals. And I can invest those systemic withdrawals and have those future gains taxed at the lower capital gains rate.

Vanguard is still going to be saving me a LOT over the next 11 years or so. The best way to look at Sun America is in your rear view mirror.

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Anyway, if you are o.k. with just paying the penalties and moving on, just set up a new 72(q) and call it a day. Again, you're paying taxes either way, with the 72(q), you avoid a 10% penalty. Without it, you owe it.

One more question that I am curious about... Had I done just one full 1035 exchange rather than a partial 1035 + a full 1035, do you think I would still be left paying the pre-59 1/2 penalties? Does that still break the 72(q) program?

I bring this up because neither insurance company rep on either side let me know that I would be paying taxes as a result of doing 2 transfers rather than one. In fact when I was wanting to do the 2nd (full) exchange a rep at Sun America mentioned to me that the first transfer should not have happened because another rep FORGOT to have me submit a SEPP cancellation election form. And then again they went ahead with the last transfer BEFORE I had submitted the filled out cancellation form. They had said that they would not be able to proceed with the last transfer until I submitted that form. They did anyway.

The reason I split it in 2 exchanges was to mitigate the risk of being out of the market. Kind of like dollar cost averaging. I explained this to the guy at Vanguard.

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I was always told that if there's an existing 72(t) or (q) distribution going on... DON'T TOUCH IT! I guess this is just one example of what can happen if you do interrupt it.

Had I done just one full 1035 exchange rather than a partial 1035 + a full 1035, do you think I would still be left paying the pre-59 1/2 penalties? Does that still break the 72(q) program?

 

[sman]

Just another example of why it's important to seek the advice of a professional BEFORE making a move.

 

[Drifting]

Just another example of why it's important to seek the advice of a professional BEFORE making a move.

Had I done just one full 1035 exchange rather than a partial 1035 + a full 1035, do you think I would still be left paying the pre-59 1/2 penalties? Does that still break the 72(q) program?

 

[Tahoe Ray]

Had I done just one full 1035 exchange rather than a partial 1035 + a full 1035, do you think I would still be left paying the pre-59 1/2 penalties? Does that still break the 72(q) program?

It is not normally advised. See my first post...

 

[Drifting]

It is not normally advised. See my first post...

So it probably had no bearing on anything.... Partial 1035 or full 1035 I was still going to pay for back taxes and interest on the withdrawals.

I spoke with an accountant today and they said that I should be able to get some free explanations from these insurance companies. So I am going to speak to both Sun America and Vanguard and have them explain to me where in the prospectus contracts is says no continued SEPP if there's a 1035 of any kind.

By the way Vanguard told me that they "were not able to code it as a 2", whatever that means.

 

[scagnt83]

Drifting,
It is unfortunate that you are having to go through this. But, I do thank you for sharing this with us. This thread has to be one of the most interesting (from an agents perspective) we have had in the Annuity section in a long time. Lots of things going on here to learn and keep in mind for us agents. 72(q) & 72(t) are subjects that do not come up often at all for agents.

While it is unfortunate for you, by sharing this it will help agents who read it become more knowledgeable, and possibly even prevent a similar mistake for one of their clients.

I havent responded to your questions yet because my 72q knowledge in my head is limited. But, I have the resources to get the answers and have done so for you. See below:

(disclaimer: Speak with a CPA. Not an accountant, a CPA. This is not tax advice, legal advice or otherwise. This post or any others do not constitute an agent/client relationship, or professional financial advice)

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By the way Vanguard told me that they "were not able to code it as a 2", whatever that means.

Ok. Last question first.

The "2" that they are not able to code it as, is referring to part of the 72(q) tax code.


Technically you are not doing a 72(q).
You are doing a 72(q)(2)(D).

Section 72(q) has subsections 1 & 2.
(1) states that a 10% penalty will be imposed on Annuity withdrawals.
(2) lists the exemptions to (1).

So 72(q) subsection (2) has a list of exemptions that are titled from A-J.
(D) happens to be the exemption for "substantially equal payments of no less than 5 years".


So long story short. What you did was take an exemption under 72(q)(2)(D).

So when Vanguard said they could not code it as a (2), that means they can not classify it under internal revenue code 72(q)(2) (the exemptions).
Instead, it must be classified under 72(q)(1). Which just states that it gets a 10% penalty no matter what.


As a side note to the agents out there:
72(q) refers to all NQ annuity distributions. The 59 1/2 rule is actually an exemption from 72(q)(1) which states that all nq annuity distributions are incur an extra 10% tax. The 59 1/2 exemption is actually 72(q)(2)(A).

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Partial 1035 or full 1035 I was still going to pay for back taxes and interest on the withdrawals.

That is correct.

This issue was laid to rest in 2008 by Revenue Procedure 2008-24. (Rev. Proc. 2008-24).
Which was then amended in 2011 by Rev. Proc. 2011-38. (bottom of page 3 covers your situation)


Long story short.
The only exemptions under 72(q)(2) that DO NOT qualify to do a tax free 1035 exchange (what you attempted to do), are (D) (as in 72(q)(2)(D) what you had started) and (I).
In other words: A 72(q)(2)(D) is not able to be transferred as a 1035 exchange. If you do anything but take the exact amount of SEPPs each year, the 72(q)(2)(D) is violated and you owe taxes on distributions. Again, it cannot be transferred as a 1035 exchange.

So now the IRS treats the transfer not as a 1035 exchange, but as a taxable distribution used to purchase a new annuity contract. This is all stated in the link I provided above.

IRC sec. 72 for reference (page 394 right hand column)

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I spoke with an accountant today and they said that I should be able to get some free explanations from these insurance companies. So I am going to speak to both Sun America and Vanguard and have them explain to me where in the prospectus contracts is says no continued SEPP if there's a 1035 of any kind.

Any explanation from the insurance company is free..... now if the accountant is on the call with you, thats when it might not be free for you...

The situation has nothing to do with the prospectus...

I would keep shopping around for an accountant, preferably a true CPA or Tax Attorney. They have more training in these technical matters, plus more resources to get the answers needed.

The fact that he thinks the answer is in the prospectus is a big red flag showing that he is not well versed in this area at all.

This is a tax/irs issue. This is not company policy of Sun America or Vanguard, it is Tax Law. (well, it is their company policy because their policy is following tax law)
But the prospectus has nothing to do with it. It only gives info on the investments/product. This is a tax code/classification issue that the product itself has nothing to do with.

As an example:
72(q) only applies to Non-Qualified Annuities. But the annuity product you have could be a Qualified Annuity depending on the source of funds. Then 72(q) would not apply at all, 72(t) would.
This is not stuff that a prospectus covers. This is stuff that the IRS tax code covers. This is why the tax attorneys in their compliance department are the ones who caught it.


At this point, the only thing to do is raise hell about the fact that the customer service rep misled you and caused you to incur unnecessary taxes.

You could possibly free look (cancel without penalty within the state required time period) the new contract and reinstate the old one and continue your 72(q)(2)(D) payments. This may or may not keep the exemption intact. I would ask Sun America's compliance department that question.

But, you seem to want the Vanguard annuity even with the taxes. So that brings me back to the "raise hell" statement. Because what you did does not qualify as a 1035 and it disqualified you from your 72(q)(2)(D) exemption.

I hope this helps and is all understandable. Feel free to ask any questions.