Can you 1035 an annuity to a life insurance policy?

Life Insurance and Annuities

Life insurance policies and annuities are both financial products that accomplish specific things. Both are financial instruments that can only be issued and maintained by life insurance companies by law.

Both types of financial instruments accumulate money on a tax-preferred basis under certain rules governed by IRS rulings, and it is important to be aware of these rules and to act by the principles set forth by these precepts.

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–Life Insurance

Life insurance provides a death benefit to a named beneficiary in exchange for annual or single premiums, should the named insured individual die. Permanent life insurance policies accumulate cash values and in some policies dividends and interest. The cash values and interest that are inside of a life insurance policy accumulate on a tax-deferred basis.

Some life insurance policies can be “over-funded” so that additional cash can accumulate on the tax-deferred basis allowed by law. There is a cap on how much money can be put into a life insurance policy before it ceases to exist as life insurance. This limit is called the “Modified Endowment” limit of funding.

–Annuities

Annuities were originally designed to pay out an income to a beneficiary from a lump sum of money. Over the years, accumulation annuities were designed to help people deposit funds over a period of years, and then pay a lifetime income upon that person’s retirement.

The money in an annuity enjoys a tax-deferred status until it is paid out on a special taxable method specified by the IRS.

Tax Advantages

Both life insurance and annuities enjoy the tax advantage of a tax-deferred inside buildup of money over time. This simply means that money that is left in these financial vehicles is not taxed on any interest earned until money is withdrawn at a later date.

Usually, the purpose for long-term accumulations of money in these financial instruments is to save money for retirement. When money is withdrawn from an annuity or a cash value life insurance policy, it can be withdrawn under favorable tax conditions at that time.

Transferring Dollars From and Annuity To A Life Insurance Policy Using the 1035 Exchange Rule

The 1035 exchange rule allows the rolling over of the values of a “like kind” of a non-qualified annuity or life insurance policy of another annuity or life insurance policy. The transfer of funds must be to an instrument of greater value, and if that is the case, there will be no ordinary income tax or capital gains tax levied on the transaction.

Under Section 1035 there are just three situations where such a transaction can occur.

• An annuity to another annuity
• A Life Policy to another life policy
• The life insurance cash value to an annuity

Consequently, there is no allowance for a 1035 exchange to allow the transfer of funds from an annuity to a life insurance policy. One purpose for wanting to create an annuity transfer of cash to a life insurance policy is to provide funds to pay for the life insurance and have it accumulate in the life insurance policy.

This could offer greater benefits to the individual with a death benefit where there had been none before, and equal or higher potential for cash accumulation. To make a transaction like this happen, one would have to cash in or surrender the annuity and pay the fees and taxes, and then use what money is left to fund the life insurance transaction.

The Problem With a Section 1035 Exchange From An Annuity to A Life Insurance Policy

The IRS Section 1035 exchange rules state that the transfer of funds from one financial instrument to another must be made from “like kind” financial instruments.

Like kind instrument transactions include the following:

• Life insurance contracts for life insurance contracts
• Life insurance contracts for endowment contracts
• Life insurance contracts for non-qualified annuity contracts
• Endowment contracts for endowment contracts
• Endowment contracts for non-qualified annuity contracts
• non qualified annuity contracts for nonqualified annuity contracts

There is no provision for an annuity to life insurance transfer in this list of allowable 1035 exchange transactions. The primary reason for this exclusion is most likely the complexity of life insurance contracts that exist and the possibility of creating a new life contract that would be illegal in several ways.

–Transfers Must Be Made From an Old Contract To a New Contract

Care must be taken when dealing with any withdrawal or taking of money from an annuity. The money is easy to get out; it is just that in the process the annuity owner has a very large possibility of really being hurt by fees and charges if the money is taken at an inappropriate time. Annuities can have lots of provisions that people can forget about since they purchased the annuity and care must be taken to preserve those benefits.

Benefits such as bonus could be in danger of being forfeited, early surrender charges could apply, and these can be quite heavy.

Many various annuities that are sold for investment purposes don’t begin to be attractive until the money has been left in the annuity for at least ten years. A pretty case can be made for the transfer to an attractive life insurance policy, but it may or may not be in the best interest of the annuity buyer.

Since money must be transferred from an older contract to a newer one, it is presumed that a life insurance policy with newer features could be very attractive, but it may or may not be given a compatible transaction from an actuarial standpoint.

The additional money could cause the new policy to be a modified endowment which could cause a disparity of money coming out of the annuity.

–Other Potential Problems

Underwriting for the newer life insurance policy could also be affected. There might be health factors that come into play, so the intended consequences of the transaction might not happen timely enough for a final decision to be made although the money would have already left the cocoon of the annuity contract.

Some underwriting processes could delay the timing of the entire transaction and cause an unintended taxable event stemming from an uncontrollable event. In a case like this, it is possible that the IRS would rule that the funds were not being transferred from “like contracts” since an annuity requires no underwriting.

Situations Where a Section 1035 Exchange Would Be Beneficial

Reasons for a 1035 exchange of funds from one contract to another takes careful planning and consideration and is usually done for specific financial reasons such as:

• Charges and fees in the old contract are excessive, and a newer contract may have better considerations in this area
• The interest rates in the newer contract may be a lot better than in the older contract
• The financial standing of the company of the current financial instrument has deteriorated to the point where a change would be a very positive move
• The money in the older contract is showing a meager return, and it can be better used in a qualified long-term care product

In Conclusion

The process of implementation of an IRS Section 1035 Exchange can be arduous and complex, it can provide a very valuable advantage for investors who wish to improve their situation from a contract that is mediocre at best, to a more favorable contract.

If done properly, there are no tax consequences. If done poorly, the taxes can make the transaction become a very negative experience for the investor.

Just about every kind of exchange between insurance-oriented products is allowed with the exception of the transfer of annuity funds to a life insurance policy. The reason for that is that there are other factors about this form of transaction that can cause unknown and unforeseen problems that can cause adverse results.

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