2 minute read: A 1035 tax-free exchange is simply an I.R.S. tax code. It 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.
3 types of a 1035 exchange:
- Annuity to Annuity Transfer
- Life Insurance to Life Insurance Exchange
- Life Insurance Cash Value to Annuity Policy
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 existing annuity, you will first have to annuitize (or surrender) your 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 a volatile variable annuity for a more conservative fixed or indexed account. There are many reasons you might want to rollover a non-qualified annuity.
This type of exchange only defers taxation if you are moving from one non-qualified annuity to another. Non-qualified accounts are those which you have already paid taxes on the invested principal, but not the gains.
However, a qualified annuity is one where the invested balance has not yet been taxed at all – like an IRA or 403b. You can also rollover IRA and 403b annuities on a tax free basis, but this 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 insurance agent/advisor and by using the proper paperwork. It is important to note there are procedures that must be done properly – otherwise the transaction can result in a taxable event. We help our clients avoid such issues.
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 this tax benefit. It’s a good idea to work with a knowledgeable agency to assure you are compliant.
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 policy and deposit the funds on a tax free basis into a new life insurance policy.
You can transfer your cash value with many policy types, 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 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 more inline with your current financial needs.
Transferring Life Insurance Cash Value To An Annuity –
If you wish, you can withdraw the cash value from your life insurance policy and transfer it tax free to an annuity account. This is the least common 1035 exchange strategy. You may not, however, 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 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.
If you are unsatisfied with your life insurance policy, it may be advantageous to transfer the cash value to a single premium 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 interest and can increase in value each year based on the performance of the policy.