Chances are pretty good that, when you purchased a life insurance policy, you did so at least partially to ensure your loved ones (especially children) would be financially secure in the event of your untimely death.
Hopefully, though, you will reach a point where your former dependents are financially independent and life insurance becomes less of a priority. For most people, that time comes around retirement age.
This is also the time when…
Lifetime annuities, and guaranteed-for-life income streams become a particularly attractive financial product for many looking to optimize their retirement years worry free.
Once one enters into their retirement years, most folks become less worried about protecting against an untimely death and more worried about outliving their retirement savings which is commonly referred to as a “longevity risk”.
The good news is…
That the tax code will allow one to exchange some existing cash-value life insurance policies and annuities for new contracts without incurring any tax liability through a transaction know as a 1035 Exchange, which is why we wanted to take a moment and discuss exactly what a 1035 Exchange is with regards to retirement savings, as well as provide you the reader with some reasons why you may want to consider this option.
What is a 1035 Exchange?
A 1035 Exchange is a transaction whereby you swap out an existing life insurance policy, annuity, or endowment for a new contract or policy that better suits your current situation.
Benefits of 1035 Exchange
When the trade takes place, the tax basis of the existing contract transfers to the new contract, and no income or capital gains taxes are owed. Earnings continue to grow tax-deferred so that you do not owe taxes for the growth until you actually see the money.
Say, for instance, you have a whole life insurance policy that has been in place for twenty years and has accrued substantial cash value.
At retirement, you decide you no longer need life insurance and instead want to use the policy’s cash value to purchase an annuity to help fund your retirement.
A 1035 Exchange lets you directly trade the whole life policy for an annuity without incurring current income taxes on the policy’s growth.
On the other hand, if you surrendered the policy for cash and used the money to buy an annuity, you would owe taxes on the growth, leaving you with less cash to fund the annuity.
1035 Exchange Options
Through a 1035 Exchange, you can trade an existing life insurance policy for an annuity, an existing annuity for a new annuity, or an existing life insurance policy for a new policy.
Note, you cannot, however, exchange an existing annuity for a new life insurance policy.
Many whole life policies include an annuitization clause, which allows you to elect to receive the policy’s cash value via annuitized payments.
While the ultimate result is similar, this is not a 1035 Exchange because the payments are received under the same contract from the insurance company.
By allowing you to swap a whole life policy for a new annuity, a 1035 Exchange effectively simulates the benefits of exercising an annuitization clause with an entirely new contract and insurance company.
1035 Exchange Rules
Usually, when you cash out a life insurance policy or surrender an annuity, you owe taxes on any funds you receive above your cost basis (“cost basis” is the aggregate premiums you have paid less any principal withdrawals). That is, any growth is taxable income.
However, if you swap one contract for another through a 1035 Exchange, you do not owe any taxes as a result of the trade.
From a policy perspective, the rule makes sense. If you cash out, you have access to the money and can basically use it for whatever purpose you want. You could purchase an annuity, but you could also buy a new car.
However, if you directly trade one contract for another, your fundamental position (i.e., how much money you have invested in the contract) remains the same – you’re just changing the details as to how you will receive the money.
The Inner workings of the 1035 Exchange
Importantly, when you make a 1035 Exchange, you never actually receive the cash. It’s exchanged between the existing and new insurance companies.
Procedurally, you irrevocably assign the existing policy or contract to the new insurer, who, standing in your place, then surrenders the policy to the insurer that issued it.
Next, the issuing insurer transfers the cash value to the new insurance company, and the new insurance company uses it to fund the new annuity or life insurance policy.
Note, if you surrender the policy, receive a check, and use the money to buy an annuity, the transaction will not be tax-free.
In the Black or In the Red
A 1035 Exchange can be advantageous whether the existing contract is “in the black” or “in the red.”
If the cash value is lower than your cost basis, the higher basis will transfer to the new contract, allowing it to accrue greater value before the growth becomes taxable.
Say you exchange a whole life policy that has a $20,000 surrender value and a $25,000 basis for an annuity. The annuity will inherit the $25,000 basis, even though it was only funded with $20,000. This allows for an additional $5,000 in growth before gains become taxable.
Now, let’s say…
You have a policy with a $25,000 surrender value and a $20,000 cost basis, so the policy is $5,000 “in the black.” If you simply cash out the policy to buy an annuity, you will owe current income taxes on the $5,000 in growth. Each dollar that goes to the IRS results in a corresponding decrease in the annuity premium and, as a result, smaller payments to you.
If you instead execute a 1035 Exchange, the entire $25,000 cash value funds the annuity, which then receives the $20,000 cost basis. The $5,000 growth itself, along with the rest of the annuity premium, continues growing tax-deferred within the annuity. Income taxes will be owed on the growth eventually but not until you actually received the money.
So, rather than getting one big lump-sum tax bill, the taxes are spread out over the life of the annuity, potentially keeping you in a lower tax bracket and resulting in decreased overall tax liability.
Requirements and Qualifications for a 1035 Exchange
To qualify for favorable tax treatment under Section 1035, the swapped-out contracts must represent a “like-kind exchange.”
A Like-Kind Exchange means that the insured or annuitant on the first contract must also be the insured or annuitant on the second contract, and the owner of the contracts must be the same. Ownership can be assigned after an exchange is completed, but you can’t change the insured.
As mentioned above, the mechanics of the transaction must occur between the insurance companies, which is why the existing contract is assigned to the new insurance company before the exchange can be completed.
To preserve the tax-advantaged status of the transaction, it’s important that the annuitant or insured not receive any of the money that changes hands.
Cannot Split Contract
As long as two or more contracts have the same ownership, they can be exchanged for a single contract, but one contract cannot be split up into multiple new contracts.
So, if you have two life insurance policies, you can convert them into a single annuity, but you can’t convert one policy into multiple annuities.
If more than one initial contract is involved, the new annuity or policy’s cost basis is simply the combined bases of the two old contracts.
Surrender Fees May Apply
Depending upon the contract language, the existing insurance company may charge a surrender fee when a 1035 Exchange takes place. The amount of the fee varies from company to company and usually decreases the longer the contract is in place.
If a life insurance policy has outstanding loans that are cancelled during the exchange, the cancelled loans can result in taxable income or decreased cost basis.
For this reason, it is usually preferable to pay off any outstanding loans prior to a 1035 Exchange.
Can you Exchange only a Portion of an Existing Policy’s Cash Value?
A “partial exchange” refers to a transaction in which only some of the value of an existing contract is transferred to the new insurance company.
The general rule is that partial exchanges are taxable if the transferred funds can be withdrawn or the contract can be surrendered within 180 days of the transfer.
However, the rule does not apply if the new contract is a single-premium immediate annuity (“SPIA”) providing payments either for life or for at least ten years.
Thus, if you exchange a whole life policy for a SPIA with lifetime payments, you can begin receiving the annuity payments immediately.
But if the new contract is a deferred annuity, you have to wait at least six months before receiving any payments to preserve the tax-free status.
Partial 1035 Exchange
If you execute a partial exchange, the new contract’s basis will be its pro rata portion of the basis of the original contract.
Say you start with a whole life policy worth $100,000 and with a cost basis of $80,000. Then, you use fifty percent of the $100,000 cash value to purchase a SPIA through a 1035 Exchange.
The basis of the new SPIA will be half the whole life policy’s basis – or $40,000.
If you receive a cash distribution of the remaining $50,000 value of the whole life policy, you would have $10,000 in taxable income after deducting the remaining $40,000 basis.
Can you Execute a 1035 Exchange with an Inherited Annuity?
If you inherit an annuity, the IRS permits a tax-free 1035 Exchange, provided certain conditions are met.
First, the swap must be one annuity for another, and the owner must stay the same. You can’t use an annuity to purchase a life insurance policy through a tax-free 1035 Exchange.
And, you can’t exchange your inherited annuity for an annuity for someone else.
Also, the exchange must be for 100% of the annuity’s value.
A partial exchange of an inherited annuity is not eligible for Section 1035’s favorable tax treatment.
And, finally, the new annuity must pay out at least as quickly as the original annuity would have. Distributions cannot be extended beyond the inherited annuity’s term.
Why Consider a 1035 Exchange?
That two-door sportscar you had in college was a lot of fun, but after you got married and had kids, it just wasn’t the right fit anymore. So, you traded it in for an SUV or a minivan.
That’s the basic idea behind a 1035 Exchange –
you swap a financial product that is no longer right for your situation for a product that better suits your current needs.
Classic 1035 Exchange Example
The classic example is to exchange a life insurance policy’s cash value for an annuity upon retirement. The dependents who once relied on you for financial support no longer do, so life insurance is no longer essential.
But, rather than cashing out for a lump sum and potentially incurring a big tax bill on the policy’s growth, you might consider spreading the tax liability out over an extended period, while locking in a guaranteed income stream for life and letting the growth continue to earn interest tax-deferred.
Additional Reasons to Consider
Of course, there are plenty of other reasons a 1035 Exchange might make sense.
Maybe you are in a better position to tolerate risk and want to switch from fixed to variable annuity payments.
Or, it could be that interest rates have gone up, and insurers are generally paying better returns.
If your health situation has improved, you may be eligible for lower premiums or a higher benefit with a new life insurance policy.
Or it could just be that an insurer has started offering a product that perfectly fits your situation.
Nobody’s financial situation stays the same forever. And I.R.C. §1035 recognizes this fact by allowing you to swap insurance and annuity contracts without taking a tax hit.
Which is why…
If your nearing your retirement age or you are realizing that you may not have saved enough money for your retirement, we would strongly encourage you to give us a call, because it’s quite possible that you may be able to “exchange” a life insurance policy or annuity for a policy that is much better suited for your needs today and significantly improve your retirement situation!
So, what are you waiting for? Give I&E a call today and see what we can do for you.