Can You 1035 Life Insurance to Annuity?

A 1035 exchange provides a method for individuals to transfer assets from one insurance product to another without triggering an immediate tax event. This provision allows for the tax-deferred reallocation of funds within certain financial instruments. This article focuses on the process and implications of exchanging a life insurance policy for an annuity.

Understanding 1035 Exchanges and Qualifying Contracts

A 1035 exchange is a provision within the U.S. tax code, specifically Internal Revenue Code Section 1035, that permits the tax-deferred transfer of funds between certain financial contracts. This allows policyholders to replace an existing financial contract with another of a similar type without incurring immediate tax liabilities. This enables asset reallocation without triggering a taxable event on any accrued gains.

The Internal Revenue Service (IRS) permits specific types of exchanges under this section, recognizing them as “like-kind” for tax deferral purposes. A life insurance policy can be exchanged for another life insurance policy, an endowment contract, or an annuity. An annuity contract can also be exchanged for another annuity contract. The exchange of a life insurance policy for an annuity fits the “like-kind” definition, allowing the cash value from the life insurance policy to be used to purchase an annuity while maintaining tax-deferred status on any gains.

The 1035 exchange provision applies to non-qualified contracts, which are those funded with after-tax dollars. While the earnings grow tax-deferred, the initial contributions have already been taxed. The ability to switch to a more suitable contract while continuing tax deferral is a primary benefit of a 1035 exchange.

Requirements for a Life Insurance to Annuity Exchange

For a life insurance policy to be successfully exchanged for an annuity under Section 1035 without triggering a taxable event, specific conditions must be met. Funds must be transferred directly from the existing life insurance company to the new annuity company. The policyholder cannot take constructive receipt of the cash value; if they do, it would be considered a taxable distribution.

The owner of the life insurance policy must be the same individual or entity as the owner of the new annuity contract. The insured person on the life insurance policy must also remain the annuitant on the new annuity contract. Changes in ownership or insured status disqualify the exchange from 1035 treatment.

Only permanent policies with cash value, such as whole life, universal life, or variable universal life insurance, qualify for this exchange. Term life insurance, which lacks cash value, does not qualify. The annuity received in the exchange must also be a non-qualified annuity. If “boot” (cash or other non-like-kind property) is received by the policyholder during the exchange, that portion becomes immediately taxable to the extent of any gain in the original policy.

Executing the Exchange

Initiating and completing a 1035 exchange from a life insurance policy to an annuity involves a series of procedural steps. The process begins with identifying a new annuity contract that aligns with current financial goals and needs.

Once a suitable new annuity is selected, the policyholder must contact both the existing life insurance company and the new annuity provider. The new annuity provider will typically supply the necessary 1035 exchange forms and instructions. These forms facilitate the direct transfer of funds from the old insurer to the new one.

Accurate and thorough completion of all required paperwork is important to avoid delays. The forms will include instructions for the direct transfer of funds, which is a critical aspect of maintaining the tax-deferred status. After submitting the completed paperwork, the two insurance companies will coordinate the transaction directly. Policyholders should monitor the process and confirm the exchange’s completion, which can take several weeks.

Tax Implications of the Exchange and the New Annuity

A properly executed 1035 exchange defers taxation on the gain from the life insurance policy’s cash value. Any accumulated earnings or growth are not immediately taxed upon transfer to the annuity. Instead, the tax liability is postponed until distributions are taken from the new annuity contract.

The cost basis from the original life insurance policy carries over to the new annuity contract. This basis represents the amount of after-tax premiums paid into the original policy. When distributions are taken from the annuity, the cost basis determines the portion of the distribution not subject to income tax.

Distributions from non-qualified annuities, including those acquired through a 1035 exchange, are generally taxed under the “last in, first out” (LIFO) rule. This means that earnings are considered to be withdrawn first and are taxed as ordinary income. After all earnings have been distributed and taxed, subsequent withdrawals are considered a return of principal and are generally tax-free.

Certain scenarios can trigger taxation during or after the exchange. If “boot” (cash or non-like-kind property) is received by the policyholder during the exchange, that amount is taxable to the extent of any gain in the original policy. Additionally, if withdrawals are made from the new annuity before the annuity owner reaches age 59½, a 10% federal income tax penalty may apply to the taxable portion of the withdrawal, in addition to ordinary income tax. This penalty is intended to discourage early use of funds intended for retirement.