Can I Change My Annuity to a Mutual Fund?

Annuities exchange premiums and the earnings on those premiums for a steady stream of cash payments that continue for a set period or for the rest of your life. During the accumulation phase, your premiums are building cash value in a variable annuity through investments in bonds, mutual funds, stocks or whatever other instruments your provider permits. If you own a fixed annuity, you simply earn interest on premiums. Your cash value freezes on the annuity date, and you must decide whether to take the money as a lump-sum payment or to start receiving periodic payments.

Before the annuity date, you can cash out your annuity and use the money to buy mutual funds or anything else you like. Most annuity providers will slap you with a surrender charge, though. In some cases, these charges start at 15 percent, but some are much higher. They decrease over time and end on or before the annuity date. Surrender charges are not tax deductible. When you cash out a qualified annuity -- one in an individual retirement account or employer plan -- you can roll the money into a traditional IRA and postpone taxes. If you don’t roll the money over, you’ll owe taxes on the full amount. You might also have to shell out a 10 percent penalty that's imposed on people who cash out qualified retirement accounts before they hit the age of 59 1/2.

Nonqualified annuities reside in taxable accounts. Earnings are tax deferred until the annuity date but become due if you surrender the policy. The taxable portion of your nonqualified annuity is the cash value minus the cost basis, which is the amount of premium money you kicked in. You treat any gain as ordinary income. If you take the money as annuity payments, you pay taxes on the portion of each payment that represents a profit above your cost basis. If you cash out the annuity before you reach age 59 1/2, you’ll have to pile a 10 percent penalty onto the taxes due. You can't roll a nonqualified annuity into an IRA.

You can perform a tax-free “Section 1035” exchange of your nonqualified annuity for a different contract, but you’ll still be on the hook for any surrender charges from the old contract. For example, you might exchange a fixed annuity for a variable one that allows you to invest in the mutual funds you wish to own. If the new annuity is with the same provider, the company might waive the surrender charge. If you move to a new provider, you can count on forking over the surrender charge. You will, however, not have to pay taxes or penalties on this type of exchange. You must, however, do a Section 1035 exchange directly from the old contract to the new one. If you receive the cash first, the deal is off and you’ll owe taxes.