Can You 1035 an Annuity to Life Insurance?

An annuity is a contract with an insurance company designed to provide a steady income stream. In contrast, life insurance is a contract that guarantees a sum of money, known as a death benefit, will be paid to designated beneficiaries upon the death of the insured person.

Understanding 1035 Exchanges

A 1035 exchange is a specific provision within the Internal Revenue Code (IRC Section 1035) that allows for the tax-free transfer of cash value from one insurance product to another. The primary purpose of a 1035 exchange is to provide flexibility, allowing individuals to adapt their financial instruments to changing needs or market conditions while preserving the tax-deferred status of their funds. Common types of exchanges permitted include a life insurance policy for another life insurance policy, an annuity for another annuity, or a life insurance policy for an annuity.

Annuity to Life Insurance Exchange Rules

A direct 1035 exchange from an annuity to a life insurance policy is generally not permitted under current Internal Revenue Service (IRS) regulations. The IRS specifies particular “like-kind” exchanges that qualify for tax-free treatment, and transferring funds from an annuity to a life insurance policy is not included in the allowed combinations. While a life insurance policy can be exchanged for an annuity, the reverse transaction does not qualify for the tax deferral benefits of a 1035 exchange. This distinction is important because it dictates how gains within the original annuity would be treated.

The IRS defines what constitutes a “life insurance contract” for tax purposes under IRC Section 7702. For a contract to qualify, it must meet specific tests, such as the cash value accumulation test or the guideline premium and cash value corridor test. These definitions are relevant for ensuring a policy maintains its tax-advantaged status, but they do not enable an annuity to life insurance 1035 exchange.

Tax Treatment of the Exchange

Since a direct 1035 exchange from an annuity to a life insurance policy does not qualify for tax-deferred treatment, liquidating an annuity to fund a life insurance policy would typically result in a taxable event. If an annuity is surrendered, any gains accumulated within the contract are subject to ordinary income tax. For instance, if the cash value exceeds the amount invested (cost basis), that excess would be considered taxable income in the year of surrender.

Additionally, surrendering an annuity may incur surrender charges imposed by the issuing insurance company. These charges are typically a percentage of the amount withdrawn, decreasing over a surrender charge period.

Once the funds are taxed and any applicable surrender charges are paid, the remaining proceeds could then be used to purchase a new life insurance policy. The cash value growth within the newly purchased life insurance policy would generally be tax-deferred, and the death benefit paid to beneficiaries is typically income tax-free.

Key Considerations for the Exchange

When evaluating the movement of funds from an annuity, several factors warrant careful consideration:

• An individual’s current health status is a significant factor, as life insurance policies require underwriting, and health conditions can influence insurability and premium costs.
• The presence and amount of surrender charges on the existing annuity should be assessed, as these fees can reduce the net amount available for transfer.
• The fees and ongoing premiums associated with a new life insurance policy also require evaluation.
• The need for a death benefit is a primary consideration; if providing a financial legacy for beneficiaries has become a central goal, life insurance may be a suitable product.
• Differences in liquidity between annuities and life insurance cash values, as well as how a death benefit integrates into broader estate planning objectives, are also important elements to review.