Can You 1035 an Annuity to Life Insurance?

A 1035 exchange allows for the tax-deferred transfer of funds from one insurance product to another, provided certain conditions are met. It is possible to exchange an annuity for a life insurance policy under these specific rules, offering a way to reallocate financial assets while preserving their tax-deferred status.

Understanding 1035 Exchange Requirements

The Internal Revenue Service (IRS) sets specific criteria that must be satisfied for a 1035 exchange to qualify. This tax-deferred treatment allows the growth within the original contract to continue compounding without being diminished by immediate income taxes upon transfer.

For an annuity to be exchanged for a life insurance policy under Section 1035, the contracts must generally be owned by the same person or entity before and after the exchange. The insured individual named on the new life insurance policy must also be the annuitant on the original annuity contract. These requirements ensure continuity of ownership and insurable interest.

A non-qualified annuity, purchased with after-tax dollars, can typically be exchanged for a non-qualified life insurance policy. This means the funds are not held within a tax-advantaged retirement account, such as an Individual Retirement Account (IRA) or a 401(k) plan. Exchanges between qualified and non-qualified contracts are generally not permitted under Section 1035 rules.

Most types of annuities, including fixed, variable, and indexed annuities, can be exchanged. Various types of permanent life insurance policies, such as whole life, universal life, and variable universal life, are eligible to receive funds from an annuity exchange. Term life insurance policies, which do not build cash value, are typically not eligible.

Basis refers to the amount of money contributed to the annuity with after-tax dollars, representing the portion of the contract’s value that has already been taxed. In a valid 1035 exchange, this basis is transferred from the original annuity to the new life insurance policy. This carryover is important for determining the taxability of future withdrawals or distributions from the new life insurance policy.

The Exchange Process

Initiating a 1035 exchange from an annuity to a life insurance policy begins with contacting both the existing annuity carrier and the prospective life insurance carrier. Each company will provide specific forms required to facilitate the transfer.

These forms typically require details about the existing annuity contract, including its policy number and current value, as well as information about the new life insurance policy being acquired. The forms usually include a specific section to designate the transaction as a direct 1035 exchange, ensuring the funds are transferred directly between the insurance companies.

Upon completion, the forms, along with any required supporting documentation such as a copy of the new life insurance policy application, are submitted to both the annuity and life insurance carriers. The critical aspect for maintaining the tax-deferred status is that the funds from the original annuity must be transferred directly from the annuity carrier to the life insurance carrier. If the funds are distributed to the policyholder, even temporarily, the transaction may be considered a taxable withdrawal rather than a tax-deferred exchange.

The processing timelines for a 1035 exchange can vary, often taking several weeks to a few months to complete. Once the exchange is finalized, both the annuity carrier and the new life insurance carrier typically provide confirmation statements to the policyholder, detailing the completion of the transfer and the establishment of the new policy.

Tax Implications of the New Policy

The portion of the cash value in the new life insurance policy that represents the original after-tax contributions remains non-taxable when accessed. Any gains accumulated in the annuity, which were tax-deferred, also transfer to the life insurance policy and continue to grow on a tax-deferred basis.

The tax treatment of withdrawals and loans from the new life insurance policy is influenced by this carried-over basis. For withdrawals, the “last in, first out” (LIFO) rule generally applies to non-Modified Endowment Contracts (MECs). This means that any accumulated gains are considered to be withdrawn first and are subject to income tax up to the amount of the gain, before the non-taxable basis is accessed. Policy loans, if the policy is not a MEC, are typically not considered taxable income, as they are treated as a debt against the policy’s cash value.

If the new life insurance policy is overfunded relative to its death benefit, it can become classified as a Modified Endowment Contract (MEC). This reclassification significantly alters the tax treatment of distributions. For MECs, all withdrawals and loans are treated as taxable income first, up to the amount of gain, and may also be subject to a 10% penalty if the policyholder is under age 59½. It is important to structure the new life insurance policy properly to avoid MEC status if tax-free loans and withdrawals are desired.

The death benefit of a life insurance policy, including one acquired through a 1035 exchange, is generally received by the beneficiaries income tax-free. This holds true even if the policy’s cash value originated from a taxable annuity.

Should an attempted 1035 exchange fail to meet all the necessary IRS requirements, the transaction could be deemed a taxable event. For instance, if the funds are not directly transferred between carriers and are instead received by the policyholder, the distribution from the annuity would typically be subject to ordinary income tax on any accumulated gains. Additionally, a 10% early withdrawal penalty may apply if the policyholder is under age 59½, similar to other non-qualified annuity distributions.