Understanding Life Insurance And Annuity With A 1035 Exchange

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract or life insurance policy for another of like kind. This means that a life insurance policy can be exchanged for an annuity, but not vice versa. The 1035 exchange provision offers flexibility for investors, allowing for the direct exchange of contracts without tax consequences. However, it's important to note that there are rules and limitations to this process, and individuals should carefully evaluate their circumstances before proceeding with a 1035 exchange.

A 1035 exchange allows for a tax-free transfer of an existing annuity contract for a life insurance policy

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract for a life insurance policy. This is particularly useful if you find a life insurance policy with better terms than your current one. It is important to note that the 1035 exchange only works one way: you can exchange a life insurance policy for an annuity, but not the other way around.

The 1035 exchange is governed by Section 1035 of the Internal Revenue Code, which allows for tax-free exchanges of certain insurance products. This is beneficial for individuals who want to transfer their life insurance, annuities, and endowments to a similar vehicle without paying taxes on any gains. The transfer must be between similar products, and the annuitant or policyholder must remain the same. For example, you can exchange a life insurance policy for another life insurance policy, or a non-qualified annuity for a non-qualified annuity.

There are a few key rules to keep in mind for a 1035 exchange:

• The exchange must be a direct transfer between institutions; you cannot cash out the contract or take money from it.
• The contract holder cannot change during the transaction.
• Exchanges must be in-kind or eligible, meaning the assets traded must be the same kind of product or fall under the allowable exceptions.

There are several benefits to a 1035 exchange, including the preservation of the cost basis, potential bonuses or improved contract terms, and increased flexibility and suitability. However, there are also limitations, such as potential offsetting charges, extended surrender periods, higher fees, and broker commissions.

Before initiating a 1035 exchange, it is important to carefully evaluate the costs, changes in terms, new features, and commissions involved. Consult with a financial advisor to determine if this is the right choice for your circumstances.

The transfer must be direct, from one institution to another

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind. This means that a life insurance policy can be exchanged for an annuity, but not the other way around.

A direct transfer is the best way to move an IRA from one institution to another since the process is handled by the institutions involved and it does not trigger taxes. To initiate a direct transfer, start by opening an IRA account at the new institution, and contact the original and the new IRA providers. You will be required to submit the necessary paperwork, and once approved, the old IRA institution will transfer the money to the new IRA institution.

An alternative to a direct transfer is an indirect transfer, where the funds first go through the account holder. The original IRA provider closes the IRA account and sends the holder a cheque, which must be deposited into the new IRA provider within 60 days.

The annuitant or policyholder must remain the same

A 1035 exchange is a powerful financial tool that allows individuals to transfer an existing annuity contract, life insurance policy, long-term care product, or endowment to another similar product without immediate tax consequences. This process is known as a tax-free transfer and is governed by Section 1035 of the Internal Revenue Code.

One of the key requirements of a 1035 exchange is that the annuitant or policyholder must remain the same. This means that the owner of the contract or policy cannot change during the exchange. For example, if Joe Sample owns an annuity, he can perform a 1035 exchange to transfer his funds into another annuity, but the new annuity must also be owned by Joe Sample. The exchange cannot be made to an annuity owned by someone else, such as Jane Sample, or a joint annuity owned by Joe and Jane Sample.

This requirement ensures that the 1035 exchange is a like-kind exchange, where the basic characteristics of the contract or policy remain consistent. It is important to note that a 1035 exchange is not simply a transfer of funds but a direct exchange of one product for another. Therefore, the annuitant or policyholder, who is the owner of the contract or policy, must remain the same to maintain the integrity of the exchange.

By maintaining the same annuitant or policyholder, the 1035 exchange provides a seamless continuation of the financial product with enhanced features and benefits. It allows individuals to upgrade their financial products, access better investment options, and adapt their financial plans to suit their current needs and goals without incurring immediate tax liabilities. This provision in the Internal Revenue Service (IRS) code offers a valuable opportunity for individuals to efficiently manage their financial portfolios.

The cost basis of the old policy becomes the basis of the new one

When exchanging an old life insurance policy for a new one, or for an annuity, it's important to understand the cost basis implications. In a 1035 exchange, the cost basis of the old policy becomes the basis of the new one. This means that the original cost of the policy, or the "cost basis", is transferred to the new policy, even if the value of the old policy has decreased.

For example, let's say you purchased a life insurance policy for $100,000, which is the cost basis. Over time, due to various factors, the value of the policy may decrease. If you decide to do a 1035 exchange and transfer that policy for a new annuity, the cost basis of $100,000 is carried over to the new annuity, despite only transferring the current value, which may be lower than the original cost.

This is an important consideration because it affects the future taxable gains or losses on the new policy or annuity. When you eventually surrender or sell the new policy, the cost basis will be used to calculate any taxable gains or losses. If the new annuity, in the above example, is surrendered or sold for more than $100,000, you will have a taxable gain. On the other hand, if it is surrendered or sold for less than $100,000, you may have a taxable loss, depending on other factors.

It's worth noting that partial exchanges are treated differently. In such cases, only a portion of the cost basis is allocated to the new product, rather than the full amount. This is another important factor to consider when evaluating the potential tax implications of a 1035 exchange.

When contemplating a 1035 exchange, it is always advisable to consult with a qualified financial advisor or tax professional to fully understand the cost basis implications and potential tax consequences. They can help you navigate the complexities and ensure you make an informed decision that aligns with your financial goals and objectives.

A 1035 exchange must be reported on a tax return

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind. It is a replacement, but not all replacements qualify as a 1035 exchange. It gets its name from Section 1035 of the Internal Revenue Code, which allows for the non-taxable exchange of certain insurance products.

To enter a 1099-R form into TurboTax, you must:

• Open or continue your return.
• In the Federal section, select Wages & Income.
• Scroll to locate Retirement Plans and Social Security.
• Select Start or Revisit next to IRA, 401(k), Pension Plan Withdrawals (1099-R).

You can also find the 1099-R section using Search. Open your return, enter 1099-r in the search bar, and select the Jump to 1099-r link.

There are three main rules to a 1035 exchange:

• Exchanges must be in-kind or eligible.
• The contract holder doesn't change.
• Institutions handle the transaction directly.

Before initiating an exchange, it is important to ask yourself:

• What is the total cost, including surrender charges, broker commission, and payments for any outstanding loans?
• Does the new contract have the benefits I need, and am I paying extra for features I don't need?
• Does the timing work for my family? For example, will resetting my life insurance contestability period put my family at risk?
• Will my age and health disqualify me from insurance altogether?

Frequently asked questions