Rule Clients may exchange a portion of an annuity contract for another annuity contract tax-free when certain requirements are met.
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The basis and income will be split pro rata between the two contracts, which creates a potential for abuse. So the IRS has placed additional rules for these types of exchanges. To qualify as a tax-free partial 1035 exchange, clients may not take a distribution from either contract within 180 days of the exchange. The IRS may treat a distribution in this time period as being a part of the original transaction. That causes the full amount of income from both contracts (up to the amount that was distributed) to be taxable, as opposed to only taxing income from the contract that distributed the funds. Taking a distribution from either contract within 180 days of a partial 1035 is likely to be scrutinized by the IRS as a tax avoidance device and may result in higher taxes, penalties and fees. An exception to the 180 day rule is if the distribution is received as an annuity for life or a period of 10 years or more.Example
An annuity owner has a $100,000 nonqualified deferred annuity with $80,000 basis and needs to take a $20,000 distribution. That full $20,000 distribution would be taxable income. If instead they take half of the $100,000 annuity and exchange it into a second annuity, each contract will have $50,000 with $40,000 basis. Without this rule, a $20,000 distribution from either contract would result in only $10,000 in taxable income.
Example provided for illustrative purposes only not indicative of any individual circumstances
What else should I know? Principal currently does not allow partial 1035 exchanges from life insurance to an annuity.
The subject matter in this communication is provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
860265-052019
A primary advantage of cash value life insurance ownership is the ability to replace an existing policy sometime in the future. There are many reasons for exchanging an existing contract, including an opportunity for enhanced performance, as well as more robust features and benefits that align better with the policy owner’s needs. Under Internal Revenue Code (IRC) Section 1035, a properly transacted exchange can result in deferred taxation of any accumulated gain until the owner surrenders (or otherwise disposes of) the newly acquired policy.
Reasons to Consider a Policy Exchange
There are many reasons to consider an exchange of an existing policy. Exchanging for a new policy can:
Reduce premiums and/or increase death benefit coverage
Older policies may use an outdated mortality table. Newer products using the current tables may have reduced mortality costs.
The insured may qualify for better rates due to health improvements (i.e., the insured is no longer a smoker).
Replace a policy not performing as projected.
Cover an insured for an extended duration to address concerns surrounding outliving the existing policy coverage.
Transition to a carrier with better ratings and financial stability.
Facilitate a change in insurance needs (e.g., policyowner now desires a guaranteed death benefit).
Allow the policyowner to obtain a policy with other desired features, such as long term care benefits.
Tax-Deferred Exchanges under Section 1035
Section 1035 of the IRC states that no gain or loss shall be recognized on the exchange of a contract of life insurance for a) another contract of life insurance, b) an endowment1 , c) an annuity contract, or d) a qualified long-term care insurance contract.
General Requirements
The insured party in the new policy must be the same as the insured party in the previous contract. (i.e., a single life policy must be exchanged for another single life policy, or a survivorship policy must be exchanged for a survivorship policy). In a private ruling, the IRS has also sanctioned 1035 treatment of the exchange of a joint and last survivor life insurance policy for a single life policy following the death of one of the insureds.2
The owner of the policy must remain the same both before and after the exchange.
Factors to Consider
The “Boot” Consideration
In most circumstances, the replacement of a life insurance policy with a new life insurance policy will result in the policyholder owning a new contract with a basis equal to that of the original contract, and will defer recognition of any taxable gain. However, the IRS has described circumstances where the policyholder receives not only a new insurance policy, but some additional payment of cash or other property as a result of the exchange. The IRS refers to these additional amounts as “boot.” If the policy holder receives “boot” in an otherwise tax-free exchange, gain will be recognized to the extent of the boot received.
Exchanges of Policies with Outstanding Policy Loans
Life insurance policies with outstanding policy loans require special care during the exchange process in order to avoid adverse tax consequences3 . The policy holder has two options when exchanging a policy with an outstanding loan:
1. Pay off the loan before the exchange. The original policy may have sufficient cash value available for withdrawal or partial surrender that can be used to pay off an existing policy loan. However, when this approach is used in close proximity to a 1035 exchange, the IRS may regard the repayment of the loan and the 1035 exchange as one integrated transaction, deeming the amount of the loan that was paid off as “boot.” It is therefore advisable to either use a source of funds outside of the policy cash values to repay the loan or wait a reasonable period of time before initiating a 1035 exchange.
2. Carry the loan over. Most insurance carriers will allow the policy owner to acquire a new policy subject to the same indebtedness as the original policy while preserving tax deferral under Section 10354 . If the policy owner allows sufficient time to pass, the loan can be repaid using a withdrawal of basis from the new policy. Although there is no specific guidance from the IRS as to how much time must elapse before the repayment of the loan using policy values will be seen as a separate transaction, some insurance carriers will treat withdrawals within the first policy year of a new policy issued with a loan as a taxable distribution.
Additional Considerations
The new policy will be subject to an initial contestability period.
The new policy will typically be issued with a surrender charge period that may last 7-20 years.
A replacement will create a new seven-year excessive premium test. Policies failing the test are subject to adverse tax consequences.
In order to justify the replacement, the benefit achieved must outweigh the acquisition costs.
In order to qualify for a replacement policy, the insured must undergo underwriting.
Conclusion
There are many valid reasons to consider replacing an existing cash value insurance policy. Section 1035 offers policyholders a way to do so while preserving basis and tax deferral of any gain. As these replacements may involve a number of financial and tax factors, it is important to consult an experienced life insurance professional who can provide the insight and experience necessary to produce successful results.
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1 An Endowment contract is defined as a contract with an insurance company which depends in part on the life expectancy of the insured, but which may be payable in full in a single payment during the insured’s life.
2 Private Letter Ruling 9248013
3 Internal Revenue Code Sections1031(b) and (c); see also Rev. Rul. 2003-56, and Private Letter Rulings 9141025 and 8905004
4 Private Letter Rulings 8806058 and 8816015
FILE 0300-2017