In the U.S. regulations allow for "in service" tax free transfer of certain accounts under specific circumstances. These type transfers may be applicable to investors holding SIMPLE IRA accounts or deferred variable annuities. Under some circumstances, investors in 403(b) plans may also be able to implement account transfers while still working for their employers. To remain tax deferred, these transfers are all trustee-to-trustee exchanges between the companies supplying the account structures.
SIMPLE IRA transfers
Although SIMPLE IRA's comprise a small part of the employer-provided qualified plan universe,  they are unique in being the sole plan that currently permits the individual employee to execute in-service trustee-to-trustee exchanges to a fiduciary of the employee's choosing. The first consideration in the selection of a SIMPLE-IRA fiduciary is to determine the type of SIMPLE IRA an employer has established, either an IRS Form 5304-SIMPLE or an IRS Form 5305-SIMPLE.
- IRS Form 5304-SIMPLE: this and similar forms of a SIMPLE IRA permit each employee to choose the financial institution for receiving contributions. The employer is required to send contributions on behalf of the employee directly to the financial institution of the employee's choice. Most participants are unaware of this option, so the employee should check with the employer to see what form was used to create the plan. Obviously, if the employee has this type of SIMPLE-IRA he can choose a low cost provider have all salary deferral and employer matches invested in low cost funds. [note 1]
- IRS Form 5305-SIMPLE: this and similar forms of SIMPLE IRA require all contributions to be deposited initially at a designated financial institution of the employer's choosing. An employee must execute trustee-to-trustee transfers in order to invest with a fiduciary of choice. During the first two years of SIMPLE IRA participation, a transfer can only be made to another SIMPLE IRA. After two years (dated from the first contribution into the plan) transfers can be made into a Traditional IRA. [note 2]
With Form 5305-SIMPLE IRAs an employee should always seek to reduce transfer costs by selecting the lowest cost fund in the employer's plan for accumulating assets for transfer. In the case of load fund SIMPLE IRA's this usually is restricted to a no-load share class of a money market fund. Since on-going salary deferrals and employer matches will continue to be deposited with the employer's fiduciary, avoiding front end loads and back end surrender charges is essential in reducing transfer costs.
Currently about 78% of the 403(b) marketplace is funded with variable and fixed annuities  Prior to September 24, 2007, individuals invested in high-cost 403(b) plans could take advantage of the 90-24 Transfer provision of the IRS code and execute in-service trustee-to-trustee transfers of plan assets to an outside fiduciary of choice. The new finalized IRS 403(b) regulations that became operational on January 1, 2009, have terminated the 90-24 provision. However, under the current interpretation of the new regulations,  in-service trustee-to-trustee transfers may still be possible if certain conditions are met. 403(b) investors may gain access to low-cost providers in two ways under the new regulations:
- The employer may select a low cost provider as an option within the plan;
- The employer may permit exchanges and establish a formal information sharing relationship with an outside low cost provider. [note 3]
If Vanguard's information sharing document is not accepted by the employer, it is possible that the documents from Fidelity, T. Rowe Price, or TIAA-CREF may be accepted, and that the employee can transfer to a 403(b)(7)[note 4] portfolio available from these providers.
Potential transfer candidates should attempt to minimize transfer costs by selecting an employer plan investment option that is exempt from front or back end loads, or stiff annuity surrender fees. Many current 403(b) investors will be subject to these surrender fees, which must be considered when accessing the feasibility of an exchange.
1035 exchanges of non-qualifying variable annuities
According to the most recent publicly available 2011 IRI Annuity factbook, variable annuities contained 1.511 trillion dollars of net assets at year end 2010.  Since variable annuities are typically burdened with high insurance costs and stiff back end surrender fees, a tax-free exchange of high cost contracts to a no-load, no surrender fee, low cost variable annuity is clearly warranted for most non-qualifying annuities. [note 5] This type of transfer is known as a 1035 transfer [note 6] The transfer decision can be quantified using a spreadsheet template similar to the one offered by Dr. Moshe Milevsky as an adjunct to his paper Exchanging Variable Annuities: An Optional Test for Suitability. The annuity option variables to include in a calculation are (quoting Milevsky):
- Lapse value. This captures the cash-flow that comes from liquidating or surrendering the policy – possibly after paying a contingent deferred surrender charge (CDSC) – and is tied to the evolution of the market value of the sub-accounts. Most investors purchase VAs exclusively for their lapse value since they view the instrument as a (tax-preferred) savings vehicle. Therefore, when contemplating an exchange, the policy holder should be cognizant of the discounted lapse value (DLV) of the new policy. All else being equal, the greater the contingent deferred surrender charges (CDSC) on the new policy and/or the greater the Mortality and Expense Risk Fees (from here, abbreviated M&E Fee) relative to the old policy, the lower the discounted lapse value, and the less likely it is that an exchange will add economic value to the investor.
- Death value. Most VA policies contain some form of guaranteed minimum death benefit. This guarantee comes in various shapes and flavors, but usually consists of a return-of-premium guarantee together with a minimally guaranteed interest rate and/or anniversary step-up feature, which periodically raises the minimum guarantee to market value. And, while these guaranteed minimum death benefits (GMDB)(as they are collectively known) have become a recent nuisance to the risk management and treasury departments within the insurance companies issuing these policies, the fact is that most consumers are more likely to lapse their VA than die and cash-in on the GMDB. Nevertheless, this embedded option must be priced in any transaction and we use the term discounted mortality value (DMV) to denote the current value of this guarantee.
- Guaranteed Annuity Rates. All variable annuity policies contain an option to annuitize – in the form of a guaranteed mortality table and interest rate -- which is poorly understood and usually ignored. Many older VAs contain annuity rate guarantees that are linked to outdated mortality tables and are thus more valuable, relative to updated mortality tables that assume a longer life expectancy. More recent VA policies offer optional guaranteed minimum income benefit (GMIB) riders which are a form of guaranteed annuity rate. In general, we use the term discounted annuity value (DAV) to denote the collection of options associated with the ability to annuitize the policy at a pre-specified mortality table and interest rate.
The spreadsheet program for quantifying the 1035 exchange can be downloaded here. [Please note that this spreadsheet is made available for educational purposes, not for commercial use.]
Inputs for the spreadsheet include:
- The client's age;
- The capital value of the Annuity. This allows one to account for any conditional surrender fees assessed upon transfer;
- The death benefit value. For a client's current contract, this value can be either "in the money" or "out of the money." An "in the money" death benefit would potentially apply to contract values after a bear market, where the insured death benefit could be greater than the current market value of the contract. A transfer would negate this insured value since the new contract would, assuming the election of a death benefit, insure only the current market value of the portfolio. In most cases, the death benefit will be "out of the money", meaning that, assuming the election of a death benefit, the new contract will provide for a higher insured value for the transferred portfolio. Vanguard offers their VA with a zero death benefit at reduced cost. The program does not allow a zero input, so one should either input a nominal value or an estimated maximum downside risk value for this zero death benefit input.
- The expense ratios of the two contracts;
- The assumed volatility of the two portfolios (standard deviation);
- The risk-free rate of return.
The output will provide the economic value of the proposed transfer. Positive values indicate that a transfer is economically suitable. Negative values indicate that a transfer is economically unsuitable.
- Vanguard offers a SIMPLE IRA. Vanguard imposes a $25 account fee per fund (waived if Vanguard assets exceed $100,000) on SIMPLE IRAs. If subject to these account fees, clients would be best advised to restrict fund selection in order to reduce costs. Vanguard's SIMPLE IRA imposes a five fund maximum limit.
- Using a Vanguard Traditional IRA avoids the $25 Vanguard SIMPLE IRA account fees. Trustee-to-trustee transfers to Vanguard are executed by: (1) filling out an IRA Transfer Request; (2) including a recent SIMPLE IRA account statement; and (3) having Vanguard execute the transfer. Trustee-to-Trustee transfers do not affect annual contribution limits to personal IRA accounts.
The IRS allows 403(b) contract exchanges with a non-payroll slot vendor if:
- the plan permits the exchange;
- the accumulated benefit after the exchange is at least the same as before the exchange;
- the employer and the non-payroll slot vendor agree to share information regarding employment and the plan’s terms;
- any pre-exchange benefit restrictions are maintained after the exchange; and
- the vendor complies with the plan’s terms. See What are the rules on in-service transfers or exchanges, IRS FAQs regarding 403(b) Tax Sheltered Annuity Plans.
- A 403(b)(7) designation refers to a 403(b) plan that is funded by investments in mutual funds
- Vanguard offers a very low cost variable annuity, the Vanguard Variable Annuity. Although not as low cost as Vanguard, additional no-load, low cost variable annuities are available from Fidelity and TIAA-CREF.
- See 1035 transfer, investopedia. The 1035 exchange also applies to transfers of fixed deferred annuities and cash value life insurance contracts.
- IRC 403(b) Tax-Sheltered Annuity Plans
- Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), Internal Revenue Service
- Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), Internal Revenue Service