You may wish to exchange your old annuity or life insurance policy for a new one for any number of reasons. Section 1035 of the I.R.S tax code allows you to do so while deferring any taxable gains in your old policy.
The gains from your old policy can be transferred to a new insurance policy on a tax free basis. You can continue to defer taxes in your new policy for a desired number of years or for your lifetime.
What is a 1035 Tax Free Exchange?
A 1035 tax free exchange is the I.R.S. tax code that allows for the rollover of a non-qualified annuity – or transfer of a life insurance policy – to a new annuity or life policy of equal or greater value. Capital gains and/or income taxes will not be realized from this type of transfer when completed properly.
There are three examples of a 1035 exchange:
- Annuity to Annuity
- Life Insurance to Life Insurance
- Life Insurance Cash Value to Annuity
The I.R.S. does not allow for a 1035 exchange from a tax deferred annuity to any type of life insurance policy. If you want to buy a life insurance policy with the proceeds from an annuity, you will first have to annuitize or surrender the annuity and pay taxes on any deferred gains.
That is not to say that trading in an annuity for a life policy is a bad idea (it can make a lot of financial sense) but it would not fall under the 1035 tax free exchange rules.
Non Qualified Annuity 1035 Tax Free Exchanges
Rolling over funds from one annuity investment to another is the most common example of a 1035 transfer. Oftentimes this is done simply to establish a new, more desirable investment.
Perhaps your old annuity is offering lower interest rates, you are interested in a first year premium bonus or you would rather exchange an unpredictable variable annuity for one with a more conservative fixed investment account. There are many reasons you might want to rollover a non-qualified annuity. (View current fixed annuity rates here)
The exchange only avoids taxation if you are moving from one non-qualified annuity to another non-qualified annuity account. (Non-qualified accounts are those where you have already paid taxes on the invested principal, but not the gains. Conversely, a qualified annuity is one where the invested balance has not yet been taxed – like an IRA or 403b. You can rollover IRA and 403b annuities on a tax free basis as well, but is not technically a 1035 tax free exchange.)
You can exchange your old non-qualified annuity for a new one with the assistance of a licensed age and by using the proper paperwork. It is important to note that there are protocols to this procedure that must be done properly – otherwise it will deemed a taxable event.
Both of the insurance companies involved will have paperwork that must be filled out correctly. If you simply cash in your old annuity and take constructive receipt of the proceeds, then it’s too late to take advantage of the tax clause. It’s a good idea to work with a knowledgeable agency (presumably us) in order to assure that you are in compliance.
1035 Tax Free Exchange Of Life Insurance Cash Value
This involves the transfer of the accumulated cash value in your old life insurance policy to a new one. You are allowed to transfer all (or some of) the cash value in your variable, universal or whole life insurance policy and deposit the funds on a tax free basis into a new life insurance policy.
There are several policy types that allow for the transfer of your cash value, but term life insurance is not one of them. Term life insurance has no cash value for the insured. Additionally, you cannot avoid income taxes by purchasing a term policy with the cash value from an existing whole, variable, universal or indexed life contract.
You might consider a 1035 life insurance exchange if you wanted to establish a new single premium paid up life insurance policy. Perhaps your life insurance needs have changed and you no longer wish to pay ongoing premiums. In other cases, you might simply want to establish a new policy that is more in line with your present needs and continue to pay premiums into the new account.
Transferring Life Insurance Cash Value To An Annuity
If you wish, you can withdrawal the cash value from your life insurance policy and transfer it tax free to an annuity account. This may be the least common of the three allowable strategies, but it can be done. Conversely, you may not transfer any gains from an annuity account to a life insurance policy without first paying taxes on the deferred gains in the non-qualified annuity.
It’s important to note that life insurance policies offer several tax advantage that annuities do not. At passing, all proceeds from a life policy can be withdrawn tax free by your beneficiaries – including the gains. And life insurance can also avoid federal estate taxes and state inheritance taxes when setup properly.
Thus, if you are unhappy with your life insurance policy for some reason, it may be advantageous to transfer the accumulated cash value to a single premium paid up policy rather than to an annuity account. If you desire safety and predictability, a single premium whole or indexed life insurance contract can be a good alternative to a variable life policy. Both indexed and whole life policies will earn fixed interest and can increase in value each year based on the declared rate or return.
In summary, there are several reasons why you might exchange an old life insurance or annuity policy for a new one. You might be seeking a higher rate of return than what your existing policy offers or you may wish to establish a more conservative investment portfolio. In the case of life insurance, you may simply wish to transfer the existing cash value to a paid up policy so you can avoid ongoing premium payments.
At Hyers and Associates, we work with several highly rated insurance companies that provide very competitive life and annuity policies for our clients. Contact us today for more information about a 1035 tax free exchange.