Can You Convert an Annuity to Life Insurance?

Converting financial products like annuities and life insurance raises questions about their flexibility and tax implications. Many individuals wonder if annuity funds can be directly transferred to a life insurance policy. While both are insurance products, rules generally do not permit a direct, tax-free exchange from an annuity to a life insurance policy. This article clarifies these products and explains the mechanisms and tax considerations for using annuity funds for life insurance.

Key Characteristics of Annuities and Life Insurance

Annuities are financial contracts designed to provide a steady income stream, often during retirement. An individual makes payments to an insurance company, which then provides regular disbursements. A feature of annuities is tax-deferred growth, meaning earnings accumulate without current income tax until withdrawals begin. Annuities help address the concern of outliving savings, providing predictable income for a specified period or for life.

Life insurance, conversely, provides financial protection to beneficiaries upon the insured’s death. Policyholders pay premiums for a death benefit paid to designated beneficiaries. Permanent life insurance policies, unlike term policies, can also accumulate cash value over time, accessible during the insured’s lifetime. This cash value grows on a tax-deferred basis, offering a living benefit in addition to the death benefit.

While both products are issued by insurance companies and offer tax advantages, their fundamental roles differ. Annuities focus on providing income during life, addressing longevity risk, and accumulating funds on a tax-deferred basis. Life insurance primarily provides a tax-free death benefit after life, offering financial security to dependents and serving as a wealth transfer tool. The distinct purposes and structures of these products influence how they can be exchanged.

The Annuity to Life Insurance Exchange

Internal Revenue Code Section 1035 allows for tax-free exchanges of certain insurance products, often called “like-kind” exchanges. This provision enables policyholders to transfer funds from one contract to another without immediate taxation on accumulated gains. The intent is to provide flexibility, allowing individuals to switch to a more suitable policy without incurring a taxable event that would otherwise occur upon surrender.

However, a direct, tax-free 1035 exchange from an annuity to a life insurance policy is not permitted. Regulations explicitly allow exchanges such as a life insurance policy for another life insurance policy, an annuity for another annuity, or a life insurance policy for an annuity. The reverse, an annuity exchanged for a life insurance policy, is specifically excluded from 1035 tax-free treatment.

If an individual wishes to use funds from an annuity to purchase a life insurance policy, the process involves surrendering the annuity contract. This means the annuity’s cash value is paid out to the policyholder. Upon surrender, the annuity contract is terminated, and any gains accumulated within it become immediately taxable as ordinary income.

The funds received from the surrendered annuity, after taxes, can then be used to purchase a new life insurance policy. This is not an exchange but a two-step transaction: a taxable distribution from the annuity, followed by a separate purchase of life insurance. The funds must pass through the policyholder’s hands, unlike a direct 1035 exchange where funds transfer directly between insurance companies. This limitation means that even if the policyholder and insured are identical, the tax-free status does not apply.

Tax Implications of the Exchange

Since a direct 1035 exchange from an annuity to a life insurance policy is not allowed, the primary tax implication arises from the surrender of the annuity. When an annuity is surrendered, any amount received that exceeds the cost basis (the premiums paid into the annuity) is considered taxable income. This gain is taxed as ordinary income, not capital gains, at the individual’s marginal tax rate.

If the annuity owner is under age 59½ at surrender, taxable gains are also subject to an additional 10% federal early withdrawal penalty. This penalty is in addition to the ordinary income tax. The combination of ordinary income tax and a potential penalty can significantly reduce the funds available to purchase a life insurance policy.

While a 1035 exchange would preserve the tax-deferred status of accumulated gains by transferring the cost basis to the new contract, this benefit is lost when an annuity is surrendered. Tax liability is triggered immediately upon receipt of funds from the annuity. Any new life insurance policy purchased with these after-tax proceeds will establish its own cost basis, and its cash value will grow tax-deferred according to its own terms.

Consider surrender charges imposed by the annuity provider. Most annuities have a surrender charge period, during which a penalty is assessed for early withdrawals or surrenders. This charge further reduces available funds, even though it is not a tax. The financial impact of these charges, combined with tax liability on gains, makes surrendering an annuity to buy life insurance a decision requiring careful consideration.