by TheProAdvisor on October 2, 2009
Annuity owners and those with cash value life insurance definitely need to pay attention to this one. The Internal Revenue Service (IRS) recently issued a revenue ruling that affects the tax-exempt status of some 1035 exchanges. It specifically relates to how the IRS will categorize partial 1035 exchanges that result in cash being removed from an existing or new annuity or life insurance policy within 12 months following a 1035 exchange.
In simple terms – if you withdraw money from your annuity or life insurance policy within 12 months of moving it to a new policy or company, you may have to pay taxes. Normally a 1035 exchange protects you from paying taxes on any gains when you change companies or get a new policy, but under these new more stringent guidelines, that may not be the case.
So why is the IRS making this change? It is an attempt to regulate individuals trying to avoid taxes through a common practice of separating the post-tax or principal contributions made to a life insurance or annuity policy from the tax-deferred growth in the policy by completing a 1035 exchange to a new account. These exchanges are technically classified as “partial exchanges”, because only a portion of the total policy value is moved to a new company or account. The portion moved is often only the growth or gains earned in the account over time from interest.
The new policy is, effectively, still classified as a non-qualified account, even though it is made up completely of tax-deferred gains and is now in essence a qualified account. The advantages to the individual involved in such a transaction are that the new policy remains exempt from Required Minimum Distributions (RMD’s). This allows the individuals involved to benefit from the growth of the account without suffering the tax consequences normally associated with RMD’s or being restricted by the early withdrawal penalties of a qualified investment.
While there are some legitimate reasons for using this partial 1035 exchange strategy, especially as it related to variable annuities with a death benefit component, most are simply a tax dodge. This tax dodge or loophole was addressed once before by the IRS through a process called “Boot”, but the restrictions imposed by “Boot” only scrutinized money being taken from a policy for a period of 30 days prior to and after an exchange.
Going forward, all partial 1035 exchanges from an existing annuity or cash value life insurance contract to a new annuity or life insurance policy will not be taxable unless certain conditions are met. The exchange will remain tax-exempt if:
- No surrenders or distributions occur on either contract in the 12-month period following the exchange;
or
- The only distribution taken from the contract is because one of the following occurred during the 12-month period following the partial exchange:
- Attained age 59 ½
- Death
- Disability
- The distribution is associated with premiums contributed before August 14, 1982.
- A life event (such as divorce or loss of employment) occurs between the date of transfer and the date of the distribution.
Bottom line, if you make a partial 1035 exchange and then take a distribution from or surrender any portion of the old or new contract within the first 12 months following the exchange, and do not meet one of the conditions listed above, the exchange will be considered a taxable event and will be reported to the IRS.
This is a complicated topic and it should be thoroughly discussed with your “Financial Professional” and CPA or tax-preparer prior to completing a partial 1035 exchange. Remember, there is never a good reason to delay making your financial future better.
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by TheProAdvisor on August 26, 2009
When it comes to investments, there are generally two types – Qualified and Non-qualified. So what exactly do these two terms mean? They specifically relate to the tax treatment of the investment, or in simpler language, how the investment is taxed.
A Qualified investment is one where the taxes on the invested dollars and interest earned have NOT been paid yet. The most common examples of this would be your 401k, 403b, Individual Retirement Account (IRA), or an employer profit sharing plan. All of these plans work in the same basic way – money earned by you is invested into a qualified account on a pre-tax basis. This means that no taxes have been paid and the investment earns interest over time on a tax-deferred basis.
Several important notes to consider before using a qualified investment account. First, the money is intended specifically for retirement and as such has very strict guidelines surrounding its use – specifically, a ten percent penalty tax for withdrawing money prior to age 59 ½. Additionally, there is a prerequisite for mandatory withdrawals, called Required Minimum Distributions or RMD’s from the account starting at age 70 ½ with HUGE (up to 50 percent!) penalties if you do not comply. Finally, there are annual contributions limits to all qualified accounts and there may be income limitations based on your plans design.
The advantage of using a qualified investment account is that you are able to utilize more of your money for your investment, because no taxes have been paid thereby leaving a larger amount of your earnings available. Furthermore, the tax-deferral on future earnings means that the account grows at a faster pace versus investments that have to pay taxes as interest is earned or prior to the investment being made. Additionally, many qualified accounts – specifically 401k and profit sharing plans may include an employer matching contribution or additional investment provided by the employer as part of the qualified plan.
With a Non-qualified investment, taxes are paid prior to the investment being made. The advantage of these plans is that the post-tax money invested is considered the cost basis of the investment. The cost basis of the investment is the portion that will not be taxed again as interest is earned or withdrawals are made.
How and when taxes are paid on non-qualified accounts can be tricky. Like qualified investments, the money in some non-qualified accounts can earn interest on a tax-deferred basis. This tax-deferral allows the investment to grow on a compounding basis, allowing the money to accumulate faster. This is most common on annuity and cash value life insurance products. Other non-qualified investments like stocks and mutual funds don’t pay taxes until the underlying investment asset is sold. Non-qualified investments like Bonds, CD’s, and savings accounts pay taxes annually on the interest they earned during the previous year.
Several key benefits to non-qualified plans are their open design, lack of income or contributions limitations, and general ease of use. Additionally, there are no requirements for minimum distributions or tax penalties for withdrawals prior to age 59 ½.
There is one other category of investment account – the ROTH. A ROTH account is technically a qualified investment, but it acts more like a non-qualified asset in many ways. First, an investment in a ROTH account is made with post-tax dollars. Second the money is allowed to grow tax-deferred. And finally and most important, all subsequent gains are tax-free. I know, it almost sounds too good to be true, and in some ways it is. The biggest drawback to the ROTH account is the ROTH contribution and income limits that affect its use.
Obviously this is only a broad overview of the different investment options and account types available. It is however a good place to start on your financial planning and education. More importantly, because there are so many options when investing, it is vital to work with a true “Financial Professional” who can help you determine which type of investment meets your needs best. Don’t delay; there is never a good reason to wait on improving your financial future.
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