Can you 1035 exchange an annuity to life insurance?

A 1035 exchange is an IRS regulation allowing a person to exchange an existing annuity for another annuity, a life insurance policy for another life insurance policy, a life insurance policies cash value for an annuity, or an endowment contract for another endowment contract, without incurring taxable income on the gains in the initial contract.

In essence, the IRS allows individuals to exchange a contract for another contract, of like-kind, tax-free.

An annuity and a life insurance contract are not like kinds.

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What are the differences between annuities and life insurance?

A non-qualified deferred annuity is a contract where a person invests after-tax dollars for retirement income, in the future. They may invest one lump sum or make monthly installments into the contract.

They allow the interest to grow or the gains from investing in the stock market grow tax-deferred until they start taking withdrawals after they retire.

The purpose of the annuity is to provide a lifetime income that a person cannot outlive.

The advantage of an annuity is the tax deferral of gains, until you stop working, allowing for the faster accumulation of assets. When you retire, you may be in a lower tax bracket, giving you further benefits.

A life insurance policy is a contract that pays a death benefit if a person dies prematurely. It is designed to pay their surviving family the money they would have earned had they lived longer.

So, it is almost the reverse of an annuity. However, a whole life policy does accumulate a cash value, similar to an annuity.

That is why the IRS allows for the cash value of a life insurance policy to be transferred tax-free to an annuity contract.

So, a life insurance policy and an annuity have almost the opposite purpose of each other.

One protects you from outliving your stream of income, while the other protects your family from your premature death. They are not like-kind.

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Why does the IRS allow tax-free 1035 exchanges for some contracts?

The IRS allows people to exchange one annuity for another tax-free because it gives them the ability to improve on the benefits of a newer version of an annuity.

For example, in recent years, life insurance companies have added many new living benefits to annuity contracts.

You can get lifetime income guarantees and a number of other added guarantees that earlier versions of annuities did not offer.

The owner and annuitant of the 1035 exchange cannot be altered. Everything must remain the same, however, maybe the new annuity has lower fees and internal costs than the older contract.

There could be other investment options available also. 1035 exchanges of a life insurance contract for another is allowed for the same reasons.

The benefits of newer versions may be to the policyholder’s advantage. Maybe the newer versions of life insurance have lower costs associated with them or new features that allow more flexibility.

The owner of the new policy and the insured would have to be the same as on the old contract.

Things to Remember When Doing a 1035 Exchange of Like-Kind Contracts

• Even though the IRS allows 1035 exchanges of like-kind contracts, that does not mean that you will not have new surrender fees and charges on the new contract. You are in effect cutting ties with the old insurance company and setting up a new one. The new annuity contract will likely have a number of years of surrender fees and other internal fees attached to it.
• You need to look at the company’s credit rating on Moody’s and other rating services, to make sure you are getting the same or better quality company.
• If you are not out of the surrender period on your old annuity contract, you will have additional costs to do a 1035 exchange. The process does not wipe out insurance company charges and fees.

Keeping the Same Basis

When you do a 1035 exchange correctly, the gain on your original policy stays with the policy and is transferred on, tax-free to the new contract.

This means that your cost basis will remain the same as it was on the old contract.

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How can you exchange a 1035 annuity for a life insurance policy?

If you have a 1035 annuity contract and you want to exchange it for a life insurance policy, there are several things you need to be aware of.

• You will need to surrender your annuity contract or a portion of it and then apply for the life insurance policy. Remember to check the death benefit on your annuity contract. Many of them have stepped up death benefits, so you may be doing yourself a disservice if you ignore this aspect of the contract.
• Taking a withdrawal from the annuity is a taxable event. You will have to pay income taxes on all gains that are withdrawn from the annuity contract.
• You may have to pay surrender fees on the annuity if the contract still has them.
• If you have not yet reached the age of 59 ½, you will pay an additional 10 percent penalty for early withdrawal from the annuity.
• You will have to meet the requirements of insurability for the life insurance policy. This may mean taking physical exams, having medical records examined, etc.
• If you get the life insurance policy, you should make regular payments for more than seven years, or the IRS will consider your life insurance policy to be a Modified Endowment Contract (MEC), which does not have the tax benefits of a regular life insurance policy.

For instance, if you take a lump sum from your annuity and pay up a life insurance policy (MEC), the IRS treats the policy like an annuity.

If you withdraw money from this type of policy before you are 59 ½ you will pay a 10 percent early withdrawal penalty. This defeats one of the benefits of doing an exchange.

MECs are also taxed by the IRS using the LIFO method, meaning that gains are taxed first on any withdrawals, rather than as a percentage of each withdrawal like you do with an annuity at retirement.

Recommendations for Changing an Annuity into a Life Insurance Policy

If you truly feel that the best financial strategy for you and your family is to use your annuity contract to fund a life insurance policy, take a withdrawal of the first year’s premium on your life insurance policy from the annuity.

Apply for the life insurance, and pay the first year’s premium. Withdraw enough from the annuity each year to pay one year’s premium for the life insurance policy.

This way you can still benefit from the growth the annuity gives you each year.

You will pay a smaller amount of taxes and fees for the withdrawal each year, and you will still have the benefits of the annuity in addition to the benefits of the life insurance policy.

In conclusion, you now know that you cannot do a 1035 exchange of an annuity for a life insurance policy because they are completely different types of contracts.

The two types of contracts provide completely different benefits to the contract owner, annuitant and insured.

Remember, the reason the IRS allows a 1035 exchange, in the beginning, is to help people benefit from the improvements in the contracts over the years.

You can see that exchanging an annuity for a life insurance contract outright, does not even appear to be an advantage.

So, follow the recommendations in this article if you plan to exchange an annuity for a life insurance plan. You can have the benefits of both contracts if you do it the right way.

You can have the benefits of both the annuity and the life insurance by simply using withdrawals from the annuity to fund the payments for the life insurance each year, maintaining the benefits of the life insurance and the annuity together.

Pay the taxes on the withdrawals from the annuity each year, and maintain the tax advantage on the remaining funds inside the annuity. You will be spreading out the tax burden over a period of years.

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