In a recent private letter ruling1 , the IRS permitted an owner to exchange a tax-sheltered annuity for an annuity that was more aligned with the owner’s goals, through what is known as a “1035 exchange.” Although private letter rulings are not law, they tend to be good indicators for how the IRS would respond to the actions described in the letter.
This new development indicates that in the event that the owner of a tax-sheltered (also known as “non-qualified”) annuity dies and an heir or beneficiary inherits it, the heir or beneficiary is no longer tied to the investment that the deceased person chose. Many times, the heir or beneficiary has different investment objectives than those of the deceased. Now, as long as the annuity has not been annuitized, the annuity contract’s terms permit a lump sum payout, and the standard 1035 exchange rules are followed, you may be able to structure your inherited tax-sheltered annuity in a way that works better for you. This flexibility not only allows the inheritor to make investment changes, it also provides the opportunity to change annuity issuers, i.e. change the insurance companies, in search of a more stable company to pay the promised annuity benefit.