How Annuities Can Transform Into Life Insurance Policies

Life insurance and annuities are two different financial tools that serve distinct purposes. While life insurance provides financial security for your loved ones after your death, annuities offer a steady stream of income during retirement. In some cases, you may want to convert your life insurance policy into an annuity to meet changing needs. This decision requires careful consideration of various factors, such as your retirement goals, tax implications, and the needs of your survivors. Understanding the complexities of this conversion will enable you to make a well-informed decision that aligns with your financial objectives.

A 1035 exchange allows you to convert your life insurance into an income annuity without paying taxes on your gains

A 1035 exchange is a provision from Section 1035 in the US tax code that allows for a tax-free transfer of one life insurance policy to another similar policy. This is particularly useful for those who have accumulated significant cash value in their policies but need more time to find a suitable alternative.

Through a 1035 exchange, you can convert your life insurance into an income annuity without paying taxes on your gains. This is a useful option for those who no longer need their life insurance policy and would prefer an income stream in retirement. By exchanging your life insurance policy, you give up the death benefit but lock in income for the rest of your life or a fixed number of years. While the conversion itself is tax-free, you will pay taxes on a portion of each payout, based on the proportion of your basis to your gains.

There are some important considerations to keep in mind. Firstly, a 1035 exchange only applies when it involves the same contract holder and the same type of contract. Additionally, you may incur surrender charges from your old policy and be subject to new fees and charges on the new policy. It is crucial to consult with a financial advisor or tax professional to understand the potential tax consequences and ensure that a 1035 exchange aligns with your financial goals.

Overall, a 1035 exchange can be a valuable tool for those looking to exchange their life insurance policy for an income annuity without incurring additional tax liabilities. However, it is important to carefully weigh the pros and cons and ensure the exchange meets your specific needs and circumstances.

You can purchase an annuity/life insurance hybrid plan

You can direct transfer or 1035 Exchange your current annuity into the hybrid plan, so there is no taxable event. Both non-qualified and qualified annuities (IRA annuities) are accepted. Once the plan is issued, the insurance company will distribute equal installments from the annuity portion of the plan into the life insurance policy's cash value for a set length of time (period certain). Once the annuity has exhausted all distributions, the hybrid plan converts into a paid-up life insurance policy.

These hybrid plans are designed for older clients up to age 85. All owners will report annuity distributions as income to the IRS each year until the annuity has been exhausted. In almost every case, the owner will be taxed on a portion or all of each payout from the annuity.

For non-qualified annuities, systematic withdrawals are considered to come first out of earnings, then out of the contract's initial investment premium. This tax method is called Last In, First Out, or LIFO. The earnings portion of the withdrawal is considered taxable income to the annuitant. When non-qualified annuities are 1035 exchanged to a hybrid plan, part of each immediate annuity payout will be a non-taxable return. The remaining portion of the payout represents a taxable gain.

For a hybrid plan, the SPIA payout will be taxable as ordinary income. The annuity will receive a 1099 form for each year's taxable amount, and the company will report the taxable amount to the IRS.

$50,000 of pre-taxed premium could equal a tax-free death benefit ranging from $60,000 to $125,000, depending on age and gender.

You can withdraw from the annuity and fund a limited-pay life insurance policy

Withdrawing from an annuity can be expensive, and both the government and insurance companies discourage people from doing so by imposing high costs for early or frequent withdrawals. However, if you have a life insurance policy with cash value, you can convert it into an annuity. This will then invest and generate income based on your cash value balance.

If you are considering withdrawing from your annuity to fund a limited-pay life insurance policy, there are a few things to keep in mind. Firstly, understand the surrender charges and tax implications. Insurance companies enforce stiff penalties for withdrawing money before the surrender period ends, which is usually around six to eight years. Additionally, the federal government imposes a 10% penalty tax if you withdraw money before you reach 59 and a half years old.

Another option to consider is selling your annuity payments instead of withdrawing from them. This involves transferring your right to receive future income for a lump sum payment. While this gives you access to a larger sum upfront, it means giving up the guaranteed payment stream provided by the annuity.

Before making any decisions, it is important to consult a financial advisor to understand the potential costs and how they will impact your future income. They can help you weigh the pros and cons of each option and make a decision that aligns with your financial goals.

A life insurance annuity is different from a life annuity

A life insurance annuity is an option for those who have built up cash value in their life insurance policy and want to convert it into an annuity. This provides a guaranteed stream of income for the rest of the policyholder's life, which can be beneficial during retirement. On the other hand, a life annuity is purchased to provide a pension-like stream of income during retirement, often serving as "longevity insurance".

One key difference is the beneficiary. In a life insurance annuity, the policyholder and, in some cases, their spouse are the primary beneficiaries and receive all income payments. In contrast, with a life annuity, the primary beneficiaries are typically the policyholder's spouse, children, or other designated heirs, who will receive the death benefit after the policyholder's death.

The timing of payouts also varies. A life insurance annuity may involve a lump-sum transfer, where the policyholder surrenders their life insurance policy and uses the payout to purchase the annuity. This provides a steady income stream similar to Social Security benefits. Conversely, life annuities typically pay benefits monthly over time when annuitized.

Additionally, there are differences in underwriting requirements. Life insurance policies usually require the policyholder to apply for coverage, with acceptance based on factors such as age and health. In contrast, no underwriting is necessary for a life annuity; however, there may be age restrictions on the selected benefits.

The funding mechanisms also differ. Life insurance policies are typically funded by monthly or annual premiums paid over time, whereas life annuities are usually funded by one or more lump-sum payments.

In summary, a life insurance annuity is a way to convert a life insurance policy into a steady income stream, often during retirement. In contrast, a life annuity is purchased to provide a pension-like income stream during retirement, with benefits paid out over time. The beneficiaries, underwriting requirements, and funding mechanisms also differ between the two options.

Consult a financial advisor to understand the tax implications of your particular circumstances

When considering converting a life insurance policy into an annuity, it is crucial to consult a financial advisor to understand the tax implications specific to your circumstances. While converting a life insurance policy into an annuity through a 1035 exchange can offer tax advantages, it is important to remember that taxes will still be due on withdrawals, and the specifics can be complex.

A financial advisor can help you navigate the tax consequences of converting your policy. They can explain how the taxes on withdrawals from a non-qualified deferred annuity differ from those on withdrawals from an IRA annuity. For example, with a non-qualified annuity, withdrawals are considered to come first from earnings, then from the contract's initial investment premium, and the earnings portion is taxed as income. On the other hand, all withdrawals from an IRA annuity are subject to ordinary income taxes. Understanding these nuances can help you make an informed decision.

Additionally, a financial advisor can provide valuable insights into the potential tax implications of the different types of annuities available, such as variable or fixed annuities. They can help you navigate the complexities of tax codes and ensure you understand the tax treatment of any gains or earnings associated with your annuity. This is especially important if you are considering a hybrid annuity/life insurance plan, as the tax consequences of these plans can be more intricate.

Furthermore, consulting a financial advisor can help you assess the overall impact of converting your life insurance policy on your financial goals and tax obligations. They can guide you through evaluating the potential surrender charges, understanding the opportunity cost of giving up the death benefit, and determining how the annuity fits into your broader retirement and estate plan. By seeking personalised advice, you can ensure that you make a well-informed decision that aligns with your unique financial circumstances and objectives.

Frequently asked questions