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 IRS tax code allows you to do so while deferring any taxable gains in your old policy.
The accumulated gains in your old policy can be transferred to a new insurance policy on a tax-free basis. In most cases, you can continue deferromg income taxes in your new policy for as long as you wish.
What is a 1035 Tax Free Exchange?
A 1035 tax-free exchange is simply an IRS 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.
There are only three types of 1035 exchanges:
- 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 a life insurance policy. If you want to buy a life insurance policy with the proceeds from an existing annuity, you will first need 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
Transferring funds from one annuity investment to another is the most common example of a 1035 transfer. Oftentimes this is done to establish a new, better-performing policy.
Perhaps your old annuity has a lower interest rate, you are interested in a first-year premium bonus, or you would rather exchange a variable annuity for a more conservative fixed or indexed account. There are many reasons you might want to exchange a non-qualified annuity. (View current fixed annuity rates here)
This type of exchange only defers taxation if you move from one non-qualified annuity to another. Non-qualified accounts are those in which you have already paid taxes on the invested principal, but not the deferred gains.
Conversely, a qualified annuity is one where the invested balance has not yet been taxed at all – like an IRA or 403b. You can roll over IRA and 403b annuities on a tax-free basis, but this is not technically a 1035 tax free exchange.
You can exchange your existing non-qualified annuity for a new one with the assistance of a licensed insurance agent and by completing the proper paperwork. It is important to note this exchange must be done properly – otherwise, the transaction can result in a taxable event. We help our clients avoid this issue.
Both insurance companies involved will require properly completed transfer and replacement forms as well as a Letter of Instruction. Cashing in your old annuity and taking constructive receipt of the account balance will not meet the IRS standards.
It’s smart to work with a knowledgeable agent to ensure you comply with all 1035 rules & regulations. Failing to do so may create taxable gains that can not be undone.
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.
You can transfer your cash value into 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 want to establish a new single-premium life insurance policy. Perhaps your life insurance needs have changed and you no longer wish to pay future premiums. In other cases, you might want to establish a new policy better suited to your current financial needs.
Transferring Life Insurance Cash Value To An Annuity
You can also withdraw the cash value from your life insurance policy and transfer it tax-free to an annuity account. This is perhaps the least common 1035 exchange strategy, but still valuable in some cases.
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 advantages 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 set up properly.
If you are dissatisfied 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.
Request Assistance, Quotes And Illustrations
There are several reasons you might exchange an old life insurance or annuity policy for a new one. You might be seeking a higher rate of return or you may wish to establish a more conservative investment account. 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 premiums.
At Hyers and Associates, we work with several highly-rated insurance companies providing very competitive life and annuity policies for our clients. Contact us today for more information about a 1035 tax free exchange.