Revenue Ruling 84-65: Life Insurance to Annuity Rules

Revenue Ruling 84-65 is an Internal Revenue Service clarification that addresses the tax implications of exchanging certain insurance-based products. This ruling provides an interpretation of tax law to help individuals make informed decisions about their financial products without inadvertently creating a taxable event.

The Qualifying Exchange Transaction

Revenue Ruling 84-65 addresses transactions under Internal Revenue Code Section 1035, which permits certain exchanges of insurance policies without immediate tax consequences.

The ruling clarifies that the exchange of a life insurance contract for an annuity contract is a permissible, qualifying transaction. This allows a policyholder to move from a product designed for a death benefit to one for retirement income. It is also permissible to exchange a life insurance policy or an annuity for a qualified long-term care insurance contract.

A life insurance contract is an agreement where an insurer pays a beneficiary upon the death of the insured person. In contrast, an annuity contract pays out a fixed stream of payments to an individual, primarily as an income source for retirees. The ruling confirmed that this exchange is considered a “like-kind” exchange as defined by the tax code, a requirement for the special tax treatment.

For the transaction to qualify, it must be a direct exchange between the insurance companies. The owner of the life insurance policy cannot receive a check for the cash value and then use those funds to purchase a new annuity. The funds must be transferred directly from the life insurance company to the company issuing the new annuity contract to maintain its tax-favored status.

Tax Treatment of the Exchange

The primary tax benefit of a qualifying exchange is the principle of nonrecognition. This means that any gain that has built up inside the original life insurance policy is not recognized as taxable income at the time of the exchange. This allows the funds to maintain their tax-deferred status as they move into the new annuity contract.

A complication arises if the policyholder receives cash or other property in addition to the new annuity, a situation referred to as receiving “boot.” If, during the exchange, the policyholder withdraws a portion of the cash value or has a policy loan extinguished, that amount is considered boot and may be taxable. Any recognized gain is taxed as ordinary income to the extent of the boot received.

The cost basis of the original life insurance policy carries over to the new annuity contract. The basis is the amount of premiums paid into the original policy, less any dividends or withdrawals. This carryover basis is used to determine the taxable portion of any future withdrawals from the annuity.

Reporting the Exchange

When a qualifying exchange from a life insurance policy to an annuity occurs, the insurance companies handle the direct transfer of funds. The policyholder will receive documentation of this transaction, most commonly Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Upon receiving Form 1099-R, the policyholder should look for specific information that confirms the tax-free nature of the exchange. In Box 7, “Distribution code(s),” the form should contain the code ‘6’. This code specifically indicates a tax-free exchange of an insurance contract.

In a straightforward exchange where no boot was received, the taxpayer typically does not need to file an additional form with their income tax return to report the transaction. The Form 1099-R with code ‘6’ serves as the primary record. However, the individual should retain the Form 1099-R and all other documents related to the exchange as part of their tax records.