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.
