What’s one thing cars and drivers have in common? Both have advanced tremendously over time.

To clarify: This regards automobiles and golf clubs, not automobile operators. But consider someone who has only driven the same car or swung the same driver for many years. Expect them to be taken aback by just how improved current offerings are versus the model that’s long resided in their garage or golf bag. And that in turn spurs them to upgrade their ride or their club.

Now consider someone who owns an older life insurance or annuity contract. Once they’re made aware of the advantages provided by a newer contract, they likewise may want to trade up. A key difference, however, is that while cars and clubs typically lose value over time, life insurance (depending on the type) and annuity contracts may be worth more now than when they were purchased. Surrendering such contracts might require gains to be included in taxable income. Surrenders of modified endowment contracts and annuity contracts may also result in a 10% early distribution penalty unless an exception is applicable. Understanding the implications is a must.

1035 Exchanges: Begin With The Basics

A nonqualified, or NQ, annuity can be exchanged only for another annuity or a qualified long-term care policy. It generally is conceded that the owner and the annuitant must be the same before and after an exchange of annuity contracts. In recent years, however, some carriers have interpreted the regulation’s requirement that the “obligee” remain the same to most likely mean the owner only. A few carriers may allow an exchange where the annuitant does not stay the same. Certain others may allow an annuitant to be added but not changed. And many may still require both to remain the same.

A life insurance policy can be exchanged tax free for another life insurance policy, an annuity contract, an endowment contract or a qualified LTC policy. The owner and the insured must be the same before and after an exchange of life insurance policies. A survivorship policy cannot be exchanged tax free for a single life policy unless only one insured is still alive.

Best Interest Is Essential

While not all Section 1035 exchanges are replacements, many are. First and foremost, any replacement must be in the client’s best interest, with the client receiving a net benefit. Be sure to be in compliance with all applicable state replacement regulations and documentation requirements.

In any case, a Section 1035 exchange must be just that: an exchange, not a surrender. The policyholder cannot surrender the policy and receive proceeds. The funds in the policy must be exchanged directly between insurance companies. Clients cannot change their mind after the fact. An endorsement to another insurance company of a check that is made out in the client’s name will not be treated as a tax-free 1035 exchange.

Partial NQ Annuity Exchanges: Another Option

The IRS allows partial NQ annuity exchanges under Section 1035.

A partial annuity exchange will qualify as a tax-free exchange if no amount is received under either the original contract or the new contract during the 180 days beginning on the date of the transfer. An exception to the “no withdrawal” is provided for amounts received as an annuity for a period of 10 years or more or during one or more lives. Thus, partial annuity exchanges — from deferred annuities into certain immediate annuities — are permitted.

Basis must be allocated pro rata between contracts. A contract owner cannot transfer all gain or all basis in an effort to avoid paying taxes on any gain in a contract.

NQ Stretch Exchanges: Added Flexibility

Non-spousal beneficiaries of NQ deferred annuities may have an NQ stretch option. An NQ stretch allows non-spouse beneficiaries to take distributions of an annuity death benefit over their life or life expectancy. As the beneficiary may withdraw more at any time, it offers more flexibility than annuitization.

PLR 201330016, a private letter ruling from the IRS, permitted a non-spousal beneficiary to do a 1035 exchange of one inherited NQ deferred annuity for another one as long as the required distribution rules of 72(s) continued to be met. A PLR may not be used as precedent and applies only to the taxpayer requesting the ruling.

Not all carriers offer an NQ stretch option. Some that don’t may allow a tax-free Section 1035 exchange to a carrier that does allow NQ stretches. Others might not. A best practice may be to review NQ annuity contracts and carriers and consider moving contracts to a stretch-friendly carrier before the death of the owner or annuitant of the contract.

Protection Pivot: Life Insurance To Annuity Exchanges

Since an annuity offers only tax-deferral and not tax-free payouts, when might it be appropriate to consider exchanging a life insurance policy for an annuity contract? Two instances where such an exchange might be appropriate would be if the life insurance is no longer needed or if the life insurance policy is "underwater."

A life insurance policy is underwater when its cash value is less than the total premiums paid for it. If more has been paid into the policy than the current cash value, any loss cannot be claimed on a 1040 tax return. But exchanging a life insurance policy that is underwater to an NQ annuity can preserve the basis and allow it to be recovered tax free via the annuity payments.

Joan Jumps From Insurance To Annuity

Joan, age 55, owns a permanent life insurance policy that has underperformed and is no longer needed. She has paid total premiums of $160,000 ($16,000 annually for 10 years), but the policy’s cash value is only $115,000. If Joan desires income now, she could exchange the life policy for a single-premium immediate annuity. She executes a 1035 exchange of the $115,000 cash value into an SPIA, which would have a basis of $160,000.

She would have an exclusion ratio of 100% and would receive her payments tax free up until her basis was recovered. Payments received after that point would be fully includible in her taxable income.

If Joan prefers income later, she could exchange the life insurance policy for a deferred annuity.

Finally, Joan also can put additional funds from her savings into the annuity. By doing so, she’ll increase the monthly amount of protected lifetime income she’ll receive from the immediate or deferred annuity. Any additional premium also would be recovered tax free from the annuity payouts.

Needs Change: Solutions Can, Too

Innovations in product design, challenging economic times, changing tax policies, and evolving client circumstances and expectations may warrant review of current products. It’s important to review risk exposure and consider growth opportunity, income certainty, tax efficiency and beneficiary protection.

A Section 1035 exchange is simply another tool in the financial professional’s tool belt. Like any other tool, consideration of its use must weigh the pros and cons of the specific case at hand. Bottom line: Keep the Section 1035 exchange in mind when helping clients address retirement and legacy goals.

Deborah A. Miner, JD, CLU, ChFC, RICP, is assistant vice president of advanced markets for W&S Financial Group Distributors. She may be contacted at [email protected].