assignment of annuity contract

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What Is Collateral Assignment (of a Life Insurance Policy)?

Meredith Mangan is a senior editor for The Balance, focusing on insurance product reviews. She brings to the job 15 years of experience in finance, media, and financial markets. Prior to her editing career, Meredith was a licensed financial advisor and a licensed insurance agent in accident and health, variable, and life contracts. Meredith also spent five years as the managing editor for Money Crashers.

Definition and Examples of Collateral Assignment

How collateral assignment works, alternatives to collateral assignment.

Kilito Chan / Getty Images

If you assign your life insurance contract as collateral for a loan, you give the lender the right to collect from the policy’s cash value or death benefit in two circumstances. One is if you stop making payments; the other is if you die before the loan is repaid. Securing a loan with life insurance reduces the lender’s risk, which improves your chances of qualifying for the loan.

Before moving forward with a collateral assignment, learn how the process works, how it impacts your policy, and possible alternatives.

Collateral assignment is the practice of using a life insurance policy as collateral for a loan . Collateral is any asset that your lender can take if you default on the loan.

For example, you might apply for a $25,000 loan to start a business. But your lender is unwilling to approve the loan without sufficient collateral. If you have a permanent life insurance policy with a cash value of $40,000 and a death benefit of $300,000, you could use that life insurance policy to collateralize the loan. Via collateral assignment of your policy, you authorize the insurance company to give the lender the amount you owe if you’re unable to keep up with payments (or if you die before repaying the loan).

Lenders have two ways to collect under a collateral assignment arrangement:

• If you die, the lender gets a portion of the death benefit—up to your remaining loan balance.
• With permanent insurance policies, the lender can surrender your life insurance policy in order to access the cash value if you stop making payments.

Lenders are only entitled to the amount you owe, and are not generally named as beneficiaries on the policy. If your cash value or the death benefit exceeds your outstanding loan balance, the remaining money belongs to you or your beneficiaries.

Whenever lenders approve a loan, they can’t be certain that you’ll repay. Your credit history is an indicator, but sometimes lenders want additional security. Plus, surprises happen, and even those with the strongest credit profiles can die unexpectedly.

Assigning a life insurance policy as collateral gives lenders yet another way to secure their interests and can make approval easier for borrowers.

Types of Life Insurance Collateral

Life insurance falls into two broad categories: permanent insurance and term insurance . You can use both types of insurance for a collateral assignment, but lenders may prefer that you use permanent insurance.

• Permanent insurance : Permanent insurance, such as universal and whole life insurance, is lifelong insurance coverage that contains a cash value. If you default on the loan, lenders can surrender your policy and use that cash value to pay down the balance. If you die, the lender has a right to the death benefit, up to the amount you still owe.
• Term insurance : Term insurance provides a death benefit, but coverage is limited to a certain number of years (20 or 30, for example). Since there’s no cash value in these policies, they only protect your lender if you die before the debt is repaid. The duration of a term policy used as collateral needs to be at least as long as your loan term.

A Note on Annuities

You may also be able to use an annuity as collateral for a bank loan. The process is similar to using a life insurance policy, but there is one key difference to be aware of. Any amount assigned as collateral in an annuity is treated as a distribution for tax purposes. In other words, the amount assigned will be taxed as income up to the amount of any gain in the contract, and may be subject to an additional 10% tax if you’re under 59 ½.

A collateral assignment is similar to a lien on your home . Somebody else has a financial interest in your property, but you keep ownership of it.

The Process

To use life insurance as collateral, the lender must be willing to accept a collateral assignment. When that’s the case, the policy owner, or “assignor,” submits a form to the insurance company to establish the arrangement. That form includes information about the lender, or “assignee,” and details about the lender’s and borrower’s rights.

Policy owners generally have control over policies. They may cancel or surrender coverage, change beneficiaries, or assign the contract as collateral. But if the policy has an irrevocable beneficiary, that beneficiary will need to approve any collateral assignment.

State laws typically require you to notify the insurer that you intend to pledge your insurance policy as collateral, and you must do so in writing. In practice, most insurers have specific forms that detail the terms of your assignment.

Some lenders might require you to get a new policy to secure a loan, but others allow you to add a collateral assignment to an existing policy. After submitting your form, it can take 24 to 48 hours for the assignment to go into effect.

Lenders Get Paid First

If you die and the policy pays a death benefit , the lender receives the amount you owe first. Your beneficiaries get any remaining funds once the lender is paid. In other words, your lender takes priority over your beneficiaries when you use this strategy. Be sure to consider the impact on your beneficiaries before you complete a collateral assignment.

After you repay your loan, your lender does not have any right to your life insurance policy, and you can request that the lender release the assignment. Your life insurance company should have a form for that. However, if a lender pays premiums to keep your policy in force, the lender may add those premium payments (plus interest) to your total debt—and collect that extra money.

There may be several other ways for you to get approved for a loan—with or without life insurance:

• Surrender a policy : If you have a cash value life insurance policy that you no longer need, you could potentially surrender the policy and use the cash value. Doing so might prevent the need to borrow, or you might borrow substantially less. However, surrendering a policy ends your coverage, meaning your beneficiaries will not get a death benefit. Also, you’ll likely owe taxes on any gains.
• Borrow from your policy : You may be able to borrow against the cash value in your permanent life insurance policy to get the funds you need. This approach could eliminate the need to work with a traditional lender, and creditworthiness would not be an issue. But borrowing can be risky, as any unpaid loan balance reduces the amount your beneficiaries receive. Plus, over time, deductions for the cost of insurance and compounding loan interest may negate your cash value and the policy could lapse, so it’s critical to monitor.
• Consider other solutions : You may have other options unrelated to a life insurance policy. For example, you could use the equity in your home as collateral for a loan, but you could lose your home in foreclosure if you can’t make the payments. A co-signer could also help you qualify, although the co-signer takes a significant risk by guaranteeing your loan.

Key Takeaways

• Life insurance can help you get approved for a loan when you use a collateral assignment.
• If you die, your lender receives the amount you owe, and your beneficiaries get any remaining death benefit.
• With permanent insurance, your lender can cash out your policy to pay down your loan balance.
• An annuity can be used as collateral for a loan but may not be a good idea because of tax consequences.
• Other strategies can help you get approved without putting your life insurance coverage at risk.

NYSBA. " Life Insurance and Annuity Contracts Within and Without Tax Qualified Retirement Plans and Life Insurance Trusts ." Accessed April 12, 2021.

IRS. " Publication 575 (2020), Pension and Annuity Income ." Accessed April 12, 2021.

Practical Law. " Security Interests: Life Insurance Policies ." Accessed April 12, 2021.

Annuities 101: Using Annuities in Your Retirement Planning

What is an annuity? If that question has you scratching your head, you’re in the right place. I will break down these financial tools and the role they can play in retirement planning.

Annuities are a financial planning tool, which offers guaranteed results. These insurance policies are designed to be used in retirement, as they offer steady payouts at predetermined intervals of time, providing an income source. This payout plan is similar to a pension, but the key difference is that pensions are typically funded by an employer, while annuities are insurance products purchased by an individual. 

The earnings that annuities earn are also tax-deferred, meaning that you do not pay any tax on the income until you take a payout.

How Do Annuities Work?

Annuities work by first purchasing the policy. You will pay on this policy a monthly premium for a set amount of time. After your contributions are made, the insurance company will begin to pay you back. There are two phases of annuities:

Accumulation Phase

Distribution Phase

As the names imply, an Accumulation Phase occurs when you contribute to the annuity, depositing money in either lump sums or repeatedly and routinely, depending on your product. The Distribution Phase is when the company with which you purchased your annuity will begin to distribute those funds back to you, almost like paying you back for the money you’ve invested over time.

Types of Annuities

There are also two main types of annuities, which include:

Deferred annuities

Immediate annuities

As these names imply, a deferred annuity is one that may take time to build up, and payments are “deferred” or delayed until a point you set. At that point, when you’ve both reached the appropriate time frame, as well as deposit amount, you will begin your distribution phase, with funds coming back to you over time.

Deferred annuities also have alternative products under the “deferred” umbrella. In other words, you have choices amongst deferred insurance policies, which impact the manner your annuity will work. Some include:

Fixed annuities: offer a fixed rate and never go below a set minimum

Variable annuities: offer a growth potential, still guarantee a set payout upon death

Structured annuities: opportunity for growth with guaranteed limits on risk

Fixed index annuities: grow or shrink with index performance to set caps or spreads

Immediate annuities are those that require a person to deposit a large sum, upfront, all at once. The funds are then doled out at a predetermined rate and frequency. These payments may be designed to come back to you, the investor, or are set aside for a loved one named as a beneficiary, in the event of your death.

The Benefits of Annuities

Annuities are often an inclusion in retirement financial planning, as they both offer a set return, but minimize risks against market losses at the same time. Limits can be set, rates of dispersal predetermined, and timelines adjusted for your personal needs. This offers investors options and choices!

Challenges of Annuities

On the flip side, some fear annuities because of the lack of fluidity. Once you have set your timelines and payouts, the plan is rather firm. There is a lack of liquidity associated with annuities.

Any changes may be associated with fees, and once purchased and written, there is little “wiggle room” to make adjustments, even if the market is suffering.

Are Annuities Right for Me?

Annuities can have a place in any well-balanced portfolio, but which style you select again will vary depending on your needs. Before you settle on any retirement investment plan, you will want to have a full understanding of the risks and rewards.

Planning for your retirement is a very personal venture. You have very unique needs, and what your neighbor finds suitable, you may not. Working closely with your financial professional is the best way to ensure you are selecting the best products for you!

Annuity contracts are not issued by Lincoln Investment or its affiliates. All contracts, features and guarantees, including optional fixed subaccount crediting rates or annuity payout rates, are backed by the financial strength of the issuing insurance company and do not apply to any subaccount. In addition, the financial ratings of the issuing insurance company do not apply to any non-guaranteed separate accounts. The value of the subaccounts that are not guaranteed will fluctuate in response to market changes and other factors. Neither Lincoln Investment, nor any of its affiliates, makes any representations or guarantees regarding the claims paying ability of the issuing insurance company. Annuity/life insurance contracts are not insured by the FDIC or any federal government agency and are not deposits of, or guaranteed by, any bank or credit union, or a provision or condition of any bank or credit union activity or Lincoln Investment or its affiliates. Annuity/life insurance contracts may have limitations and restrictions, including possible withdrawal charges and excess adjustments where applicable, may involve investment risk, and may lose value. Withdrawals of taxable amounts from an annuity are subject to income tax and withdrawals prior to age 59 ½ may be subject to a 10% federal penalty tax.

At Gretchen Rehm Financial, I work with clients to align their investments, retirement accounts, and pension plans into an integrated plan for their financial future. I have a B.S. in Public Relationships.

I love my career because I get to help families protect and plan for their futures. Owning the business also allows me the flexibility of being a mom to my three children!

I live in Henderson, MN with my husband, Reegan, and my three children: Ryker, Reese, Rogen, and our fur baby, Archie the French Bulldog. Reegan and I have been married since 2005. We spend most of our time attending hockey, baseball, volleyball, soccer, and flag football games for the three kiddos.

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26 U.S. Code § 130 - Certain personal injury liability assignments

Any amount received for agreeing to a qualified assignment shall not be included in gross income to the extent that such amount does not exceed the aggregate cost of any qualified funding assets .

A prior section 130 was renumbered section 140 of this title .

1997—Subsec. (c). Pub. L. 105–34, § 962(a)(1) , inserted “, or as compensation under any workmen’s compensation act,” after “(whether by suit or agreement)” in introductory provisions.

Subsec. (c)(1). Pub. L. 105–34, § 962(a)(2) , inserted “or the workmen’s compensation claim,” after “agreement,”.

Subsec. (c)(2)(D). Pub. L. 105–34, § 962(a)(3) , substituted “paragraph (1) or (2) of section 104(a)” for “section 104(a)(2)”.

1988—Subsec. (c). Pub. L. 100–647 , in par. (2), redesignated subpars. (D) and (E) as (C) and (D), respectively, struck out former subpar. (C) which provided that the assignee does not provide to the recipient of such payments rights against the assignee which are greater than those of a general creditor, and as concluding provisions, inserted at end “The determination for purposes of this chapter of when the recipient is treated as having received any payment with respect to which there has been a qualified assignment shall be made without regard to any provision of such assignment which grants the recipient rights as a creditor greater than those of a general creditor.”

1986—Subsec. (c). Pub. L. 99–514 inserted “(in a case involving physical injury or physical sickness)”.

Pub. L. 105–34, title IX, § 962(b) , Aug. 5, 1997 , 111 Stat. 892 , provided that:

Pub. L. 100–647, title VI, § 6079(b)(2) , Nov. 10, 1988 , 102 Stat. 3710 , provided that:

Pub. L. 99–514, title X, § 1002(b) , Oct. 22, 1986 , 100 Stat. 2388 , provided that:

Pub. L. 97–473, title I, § 101(c) , Jan. 14, 1983 , 96 Stat. 2606 , provided that:

Assignment Of Annuity Contract For Consolidation Is Tax-Free Exchange.

Rev. rul. 2002-75; 2002-2 c.b. 812.

• Institutional Authors Internal Revenue Service
• Code Sections Section 1035 Section 72
• Subject Areas/Tax Topics Insurance
• Industry Groups Insurance
• Jurisdictions United States
• Language English
• Tax Analysts Document Number Doc 2002-25168 (1 original page)
• Tax Analysts Electronic Citation 2002 TNT 218-80

Rev. Rul. 2002-75

[1] Is the taxpayer's assignment of an entire annuity contract to a second insurance company, which then deposits the cash surrender value of the assigned annuity contract into a pre-existing annuity contract owned by the same taxpayer, and issued by the second insurance company, a tax-free exchange under § 1035? What is the basis under § 1035 and the investment in the surviving contract under § 72 after the transfer?

[2] A owns Contract B, an annuity contract issued by Company B, and Contract C, an annuity contract issued by Company C. A is the obligee for both contracts. A seeks to consolidate Contract B and Contract C. A assigns Contract B to Company C. Company B transfers the entire cash surrender value of Contract B directly to Company C. Company C includes the transferred cash surrender value of Contract B in Contract C. A will not receive any of the cash surrender value of Contract B that is transferred to Company C and deposited into Contract C. No other consideration will be paid by A in this transaction. The terms of Contract C are unchanged by this transaction, and Contract B terminates.

LAW AND ANALYSIS

[3] Section 1035(a)(3) provides that no gain or loss shall be recognized on the exchange of an annuity contract for an annuity contract. Section 1.1035-1 of the Income Tax Regulations provides that the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under § 1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees under the contract received in the exchange as under the original contract.

[4] The legislative history of § 1035 states that exchange treatment is appropriate for "individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain." H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954).

[5] Section 1035(d)(2) cross-references § 1031 for the rules to determine the basis of property acquired in a § 1035 exchange. Section 1031(d) provides that property acquired in a § 1035 exchange has the same basis as that of the property exchanged, decreased by the amount of any money received by the taxpayer and increased by any gain (or decreased by any loss) recognized by the taxpayer on the exchange.

[6] Section 1.1031(d)-1 provides, in part, that in a § 1035 exchange the basis of the property acquired is the same as the basis of the property transferred by the taxpayer with proper adjustments to the date of the exchange.

[7] Section 72 governs the federal tax treatment of distributions from an annuity contract. For purposes of determining income, gain, or loss from an annuity contract, § 72 contains two special definitions of investment in the contract. When amounts received are not annuity payments, § 72(e)(6) defines the investment in the contract. For purposes of § 72(b), which applies to annuity payments, § 72(c)(1) defines the investment in the contract in a similar, but not identical, manner.

[8] After completion of the transaction, A owns only Contract C, which has been increased in value to reflect the cash surrender value transferred into it from Contract B. A had no access to the cash surrender value transferred in the exchange. Therefore, this transaction is treated as an exchange that is tax-free under § 1035.

[9] As a result of the application of § 1035(d), A's basis in Contract B is included in A's basis in Contract C immediately after the exchange, and under § 72(c)(1) and § 72(e)(6), A's investment in Contract B is included in A's investment in Contract C immediately after the exchange.

[10] (1) The assignment by A of Contract B to Company C for consolidation with pre-existing Contract C is a tax-free exchange under § 1035.

[11] (2) After the assignment, pursuant to § 1035, A's basis in Contract C immediately after the exchange equals the sum of A's basis in Contract B and A's basis in Contract C immediately prior to the exchange.

[12] (3) After the assignment, A's investment in Contract C under § 72 equals the sum of A's investment in Contract B and A's investment in Contract C immediately prior to the exchange.

DRAFTING INFORMATION

[13] The principal author of this revenue ruling is Ann H. Logan of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact her at (202) 622-3970 (not a toll-free call).

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Client Assistance:

Contractual changes, introduction.

This section provides instructions for completing the following changes made in an insurance policy:

The prompt and accurate completion of requested changes is vitally important to the policyowner and other parties concerned. Completing the proper forms and obtaining the required signatures at the time of the request helps ensure proper handling.

NOTE: Columbus Life does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Columbus Life cannot guarantee that the information herein is accurate, complete, or timely. Columbus Life makes no warranties with regard to such information or result obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Please advise your customer to consult an attorney or tax professional regarding their specific situation.

Change of Ownership—Traditional, Universal Life and Annuity

Items needed.

Client Services Form CL 70.57

Acknowledgment

1. Policyownership Acknowledgment to new policyowner.

2. Email Notification with message:

a. NAME CHANGE—OWNER (Traditional)

b. OWNERSHIP CHANGE (Universal Life and Annuity)

1. The signature and the date of the present owner and the signature and Tax Identification number of new owner are required.

2. A copy of the death certificate and a W-9 verifying new owner's Social Security number are required if ownership change is due to death.

3. When naming a Living Trust as owner, the following information is required:

a. Name of Trust

b. Trustee

c. Date of Trust or Trust Number

d. Copy of the first and last page of the Trust

e. Completed Verification of Trust (CL 45.915)

4. Beneficiary designations should be reviewed when changing ownership.

5. If the policy is owned by a corporation, the signatures and titles of two officers are required unless the supporting documentation shows otherwise (ex: sole proprietorship). If the insured is an officer of the corporation, the signature and title of the insured and another officer's signature are satisfactory. In addition, a Corporate Resolution/Articles of Incorporation verifying authority to sign on behalf of the corporation will be required.

6. Joint ownership is permitted by using one of two Amendments. These Amendments provide for a contingency to either the owner's estate (form CL 70.205) or surviving owner(s) (form CL 70.204) and specify the address and Taxpayer Identification Numbers to be used. The Amendment and all future requests for changes and withdrawals require all signatures and Tax Identification Numbers.

7. Naming a minor as policyowner should be avoided because a minor cannot make any changes to a contract until the minor reaches the age of majority.

See "Pros and Cons of Ownership" which follows, reprinted with permission of Stephan R. Leimberg J.D., CLU.

Pros and Cons of Ownership

The insured as owner.

a. The insured retains sole control over the policy and can unilaterally exercise all policy ownership rights and privileges.

b. The insured has the right to all policy cash values for an emergency or opportunity (subject to the terms of the policy).

a. The entire proceeds of the policy will be includible in the insured's estate for federal estate tax (and possibly state estate tax) purposes—regardless of the identity of the beneficiary.

b. A gift of the policy within 3 years of death will result in inclusion of the policy in the insured's gross estate.

Suggestion: If death tax savings are not important, in most cases the insured should be named owner of the policy.

The Spouse Of The Insured As Owner

a. It is simple to arrange this ownership form.

b. Having incidents of ownership could bring the policy back into the spouse’s estate.

c. Assuming the insured and spouse file jointly, any income tax deduction for interest paid on policy loans will be at the insured's tax bracket. (Note that if interest payments on policy loans are considered "consumer interest," such interest would be nondeductible under Section 1421 of the Tax Reform Act of 1986.)

d. If the insured transfers a policy to his spouse and outlives the "transfers within 3 years of death" period, the policy proceeds will have been removed generally at minimal or no gift tax cost.

a. Should the spouse predecease the insured, the policy may (absent provision otherwise) return to the insured either through the spouse's will or intestacy laws or under the successor ownership provisions of the policy or to children who may be legally incompetent.

b. If premiums are paid by the insured, to the extent they don't qualify for (or to the extent they exceed) the annual exclusion, a gift tax may be incurred.

c. If someone other than the policyowner-wife is named beneficiary of the policy she owns, she is deemed to be making an indirect gift of the proceeds at the insured's death.

d  The proceeds, to the extent not consumed or given away by the date of the spouse's death, will be in her estate.

e. Once the spouse becomes absolute owner of the policy, the insured has lost legal and (depending on the harmony between the spouses) effective control over the policy and its underlying rights of ownership.

If the policyowner lives in a community property state, special rules may apply.

Suggestion: The unlimited marital deduction has decreased the utility of making the insured's spouse policyowner. But if she is, have her apply for and pay premiums from her own money to avoid a "transfers within 3 years of death" argument by the IRS. (See note on community property state rules.)

Children Of The Insured As Owner

a. Adult children are easily and simply named as policyowners.

b. It is possible, depending on the circumstances, for insurance proceeds to escape taxation at the death of both the insured and insured's spouse.

c. Gift taxes are minimized by the annual exclusion if the child is the direct owner of the policy and the insured makes cash gifts to the children in the amount of the premium.

a. The insured must give up (or never have) control over the policy, its cash values, and all of its ownership rights including the right to change the beneficiary.

b. If the insured's children are minors, their legal disability may impede the use of the policy or make it costly to deal with the policy.

Irrevocable Trust As Owner

Pros (when properly created and administered).

a. Proceeds may be removed from estate of insured and can escape taxation in estate of insured's spouse.

b. Helps to avoid problems if either insured or spouse become incompetent.

c. Helps to provide greater assurance that proceeds will be integrated with insured's overall estate plan and with other policies and assets.

a. More complex than ownership by an individual. (Consultation and assistance of estate planning professional is recommended.)

b. Immediate legal costs.

c. Annual accounting and fiduciary fees when funded.

d. Can't be changed, revoked, or terminated by insured.

Change of Name—Traditional, Universal Life and Annuity

1. Client Services Form CL 70.57

2. A copy of the Court Order if the reason for the change is other than marriage or divorce.

1. Email Notification with message:

a. NAME CHANGE—INSURED or NAME CHANGE OWNER (Traditional)

b. NAME CHG INSURED or OWNERS NAME CHG—(Universal Life and Annuity)

2. Acknowledgment letter to policyowner.

1. When a change of name is due to a reason other than marriage or divorce, a copy of the court order is required.

2. If the change is due to reason other than marriage or divorce, and if the owner is a corporation, the signatures/titles of two officers are required. If the insured is an officer of the corporation, the signature and title of the insured and another officer's signature and title are satisfactory.

3. If the change is due to reason other than marriage or divorce, and the policy is owned by a pension or trust, a trustee's signature is required.

4. Beneficiary designations should be reviewed when changing the name.

Change of Beneficiary—Traditional, Universal Life and Annuity

Request for Change of Beneficiary:

a. Form CL 70.84 for Lump Sum

b. Form CL70.58 for Settlement Option

1. Acknowledgment letter.

Guidelines—Form CL 70.84

1. Side A should be completed to change the beneficiary on the Insured's coverage.

2. Side B should be completed to change the beneficiary for the spouse, Other Insured, or Children's coverage. (Review the Family Coverage Information which follows concerning coverage on the spouse, the children, and the other insured.)

3. If the beneficiary for everyone's coverage is changing, complete both sides A and B.

4. The beneficiary designation should be clear, giving the full name and relationship to the insured. Provide full name, relationship to the insured, date of birth, and social security number of beneficiary.

5. Percentages, not specific dollar amounts, should be used, if the proceeds are to be distributed among several beneficiaries.

6. If a Trust is named as beneficiary, the date of the trust or the trust number is required.

7. If a friend is named as beneficiary, both his or her Social Security Number and address are required.

8. The address and Employer Identification Number (EIN) or Tax Identification Number are required for any charitable or educational institution named as beneficiary.

9. A guardian is not an acceptable beneficiary, except as outlined in the "Writing Business" section of Marketing Manual Online.

10. When changing the beneficiary from the spouse in a community property state, the Community Property Disclaimer must be signed by the spouse.

11. The phrase "Per Stirpes" should not be used because of possible misunderstandings concerning the intent. The following language should be used: "Insured's children in equal shares. If any child of the Insured predeceases the Insured, then the share that the deceased child would have received is to be paid in equal shares to the children by birth or adoption of said deceased child who survive the Insured. If there are no children of such deceased child surviving the Insured, the deceased child's interest in this policy shall terminate."

12. These signatures are required for the following situations:

a. If owned by a corporation, the signatures/titles of two officers are required unless the supporting documentation shows otherwise (ex: sole proprietorship). If the insured is an officer of the corporation, the signature of the insured and another officer's signature and title are satisfactory.

b. If owned by a pension plan or trust, the signature of a trustee is required.

c. If there is an absolute assignment, the assignee's signature is required.

d. If the current beneficiary is irrevocable, his or her signature is required.

13. If a trust has been established within the Last Will and Testament of the insured, the following testamentary trust language should be used: "The Trustee(s) designated in and who duly qualifies according to the law under the Trust created by the Last Will and Testament of the insured. If within one year from the insured's death the Company is not furnished written due proof of the appointment or qualification of such Trustee, payment shall be made to the Executors or Administrators of the insured."

Family Coverage Information—Universal Life

Because of your recent beneficiary change, the following information may be beneficial to you. Please take the time to review the highlighted areas, and feel free to contact us or your Agent with any questions.

Basic Definitions Regarding Family Coverage:

Children's coverage, other insured's coverage, family coverage information—not universal life, basic definitions regarding family coverage, family plan policies, spouse riders, family plan riders, pros and cons of beneficiary designations, lump sum payment to an individual.

a. Naming an individual is simple.

b. There is no cost involved.

c. Designation is easily understood.

d. Payment is made without delay.

e. No expense involved in collecting proceeds.

a. There may be problems if the beneficiary predeceases the insured (proceeds go to contingent beneficiary or, if there is none, to estate of insured).

b. If the beneficiary is a minor or for any other reason is legally incompetent, a guardian must be appointed to receive the proceeds.

c. The beneficiary may be unable or unwilling to manage or invest and conserve the proceeds.

d. The beneficiary may not be willing to use any part of the proceeds to help pay the insured-client's estate taxes or settlement costs.

e. The insured-client loses the ability to influence or direct the ultimate disposition of the proceeds at the beneficiary's death, since once the beneficiary receives an outright distribution of the proceeds, the insured's wishes are— legally at least—irrelevant.

f. Proceeds remaining at the beneficiary's death are includible in her estate.

Suggestion: Use the "Rule of 2 "—Always name at least two back-up beneficiaries. Consider a charity as a final back-up beneficiary.

Payment To An Individual In The Form Of A Settlement Option

a. The election of a settlement option for a beneficiary is simple.

b. There are no out-of-pocket costs involved in selection of a settlement option.

c. Safety of principal is assured.

d. The beneficiary is relieved of management and investment responsibilities.

a. Typically, the election of a life income settlement option, once made, cannot be altered even if the beneficiary's physical condition, marital status, family situation, or financial needs change.

b. Because monthly payments are fixed, inflation reduces the purchasing power produced by the proceeds.

c. The guaranteed return is relatively low (but many companies have overcome this with competitive interest rates).

d. Proceeds may not be available to help pay estate taxes and other costs at insured's death.

e. Payments not consumed or given away by date of beneficiary's death are includible in his/her estate.

Suggestion: The settlement option may be the perfect poor man's/poor woman's trust for cases in which policy proceeds will be relatively modest.

Settlement options are always available to the beneficiary and can be elected at time of claim. It may not be prudent to "lock in" a settlement option.

Payment To Estate Of Insured

a. Naming the insured's executor as beneficiary is simple.

b. The insurance proceeds become available to the executor immediately.

c. The estate is assured of liquidity.

a. The proceeds will be subject to federal estate tax regardless of who the owner was.

b. Proceeds will be subject to state death taxes.

c. Proceeds will be in the insured's probate estate.

d. Proceeds become subject to the claims of the insured's creditors.

e. The insured's spouse can take—in most states—her "elective" or "forced" share regardless of what the insured's will provides.

f. The insured's plans are based on the will's effectiveness—and the will could be "attacked and broken."

Suggestion: This beneficiary designation is seldom if ever appropriate and could lead to malpractice suits.

Payment To Trust (In General)

a. A trust can provide for a number of contingencies such as

1. the predecease of the primary beneficiary

2. the incompetency of any beneficiary

b. Professional management and investment expertise is available.

c. Dispositive provisions can be drafted flexible enough to meet changing financial family situations.

d. Proceeds can be free from the claims of the beneficiary's creditors.

e. Proceeds can be integrated with insured's other assets and other policies.

f. Insured can—indirectly through trust provisions—continue to control ultimate disposition of proceeds.

g. A trust is a separate taxable entity for income tax purposes and makes it possible to divide income between the trust and its beneficiaries (and therefore lower income taxes).

(Note that Section 101 of the Tax Reform Act of 1986 would increase the rate schedule applicable to trusts and estates.)

a. Compared to the simplicity of naming an individual as beneficiary, this choice is relatively complex.

b. A trust must be in existence before it can be named beneficiary—this in turn may involve delays.

c. There are costs involved in the drafting of a trust and the coordination of it with other estate assets and dispositive tools.

d. A living trust may involve ongoing expenses.

e. Beneficiaries may not understand why a trust is needed or how its terms operate and must be educated.

Payment To Trust Created Under Insured's Will (Testamentary Trust)

a. It is relatively easy to name a trust created under the insured's will as beneficiary of life insurance proceeds.

b. A testamentary trust which receives life insurance proceeds directly can be funded immediately. Completion of probate proceedings is not necessary to "get things going."

c. In some states (such as Pennsylvania) naming a testamentary trust as the beneficiary of insurance proceeds will not subject insurance proceeds to state inheritance tax—but in other states insurance proceeds may unnecessarily be subjected to inheritance tax.

a. If the insured dies intestate or the will is held to be invalid because of incompetency, duress, fraud, or improper execution, there would be no trust to receive the insurance proceeds.

b. Many states have no laws specifically authorizing the naming of a testamentary trustee as beneficiary of a life insurance policy.

c. The addition of a trust to the insured's will adds to its cost and complexity.

Payment To An Inter Vivos (Living)Trust

a. Life insurance proceeds payable to an inter vivos trust can avoid probate.

b. Proceeds payable to an inter vivos trust are exempt from the creditors of the insured's estate.

c. In many states, no state inheritance taxes will be imposed when life insurance is payable to an inter vivos trust. The insured can select the state law that will control the interpretation of the trust terms.

a. Naming the trustee of a trust created during lifetime as beneficiary of a policy is—relative to naming an individual—complex.

b. There are initial drafting costs and then ongoing trustee's and accounting fees are involved once a trust is funded.

c. Some states do not consider the mere naming of the trustee of an inter vivos trust as a life insurance policy beneficiary as a sufficient transfer of property. (In other words, in some states the trust may not be valid unless other property is put into the trust.)

Suggestion: A trust should be considered in every case where postponement of ownership and limited control are desired.

Assignment of Policy—Traditional, Universal Life and Annuity

1. Absolute and collateral assignments require a Columbus Life Assignment Form CL 70.400-TRM (term policies); CL 70.400-WL (whole life policies); CL 70.400-UL (universal life policies) in duplicate. (The American Bankers Association Form No. 10 is sufficient for collateral assignments.) Signature of the policyowner is required.

2. If the Split Dollar Plan Assignment requires (PS-58) economic benefit cost information, form CL 5.601 needs to be completed.

3. To assign an annuity contract, the Withholding Notice and Election Form CL 70.400-ANN and dollar amount of assignment will be required (see guideline #6).

1. Recorded assignment form.

2. Acknowledgment letter.

1. Obtain the proper signatures with appropriate titles.

2. Check the appropriate box for the type of assignment.

3. Changes of Policyowner are recommended rather than absolute assignments.

4. The full name and address of assignee are required on Collateral and Absolute Assignment forms. Note: Columbus Life may not approve absolute assignments on existing policies.

5. With Policy Rider Assignments, confirm that the policy has the appropriate rider.

6. In accordance with the Tax Equity and Fiscal Responsibility Act of 1982, any portion of an annuity contract that is assigned will be treated like a cash withdrawal as far as tax consequences. Therefore, assignments on annuity contracts are strongly discouraged.

7. In accordance with the Tax and Miscellaneous Revenue Act of 1988, any portion of a life insurance contract that is classified as a Modified Endowment (MEC) that is assigned will be treated like a cash withdrawal as far as tax consequences. Therefore, assignments on MEC contracts are strongly discouraged.

Release of Assignment—Traditional, Universal Life and Annuity

Release portion of appropriate form or Release of Assignment Form CL 70.400-TRM (term policies); CL 70.400-WL (whole life policies); CL 70.400-UL (universal life policies), CL 70.400-ANN (annuity policies). Signature of assignee required with titles. Please also provide a copy of supporting documents to demonstrate who authorized signors are for assignee.

1. Recorded release of assignment form.

1. Assignee's signature is always required.

2. If policy is assigned to a corporation, the signatures/titles of two officers are required unless supporting documentation says otherwise. (If the insured is an officer of the corporation, the signature and title of the insured and another officer's signature and title are satisfactory.) In addition, a Corporate Resolution/Articles of Incorporation verifying authority to sign on behalf of the corporation will be required.

Maturity—Traditional and Annuity

1. A lump sum settlement can be requested on the Withholding Notice and Election Form CL 70.198. The policyowner's signature, tax identification number, and withholding election are required.

2. The Selecting a Settlement Option Form CL 70.23 needs to be completed, in full, to request a settlement option. The Withholding Notice and Election Form CL 70.198 with the policyowner's signature, tax identification number and withholding election are also required.

1. If lump sum settlement, a check representing maturity proceeds is sent to policyowner.

2. If settlement option is selected, the Settlement Contract and letter explaining the option are sent to policyowner.

1. A notification letter is sent to the policyowner approximately 40 days prior to maturity. This letter informs the policyowner of the settlement options available and the tax consequences of each. A copy of the letter is sent to the servicing agent.

Change of Settlement Contract

1. Selecting a Settlement Option form CL 70.23 must be submitted to change:

a. settlement option

b. payee designation

2. To request a surrender or partial withdrawal, form CL 70.144 should be completed.

3. Return the settlement contract.

4. The following requests can be submitted in writing:

a. name change

b. address change

c. check to be mailed to bank

Letter to payee acknowledging change.

A change may not be made if insured is deceased, unless the right to change option was granted the payee in the contract.

Establishing a Withdrawal Arrangement on an Annuity

1. Completed Request Form for Withdrawal Arrangement (CL 70.197).

1. The endorsed Request Form for Withdrawal Arrangement (which should be filed with the annuity contract), the first check and a letter of acknowledgment will be sent to the Owner.

1. $1,000 minimum withdrawal. (Must also comply with contract minimum fund balance.)

2. Complete a separate form CL 70.197 for each contract.

3. The first payment can be made no earlier than the issue date of the Deferred Annuity contract.

4. Payments are made to the Owner.

5. In the event of the annuitant's death, any unpaid proceeds shall be paid in a lump sum in accordance with the beneficiary provisions of the Deferred Annuity Contract.

6. Amounts withdrawn are subject to any applicable surrender/withdrawal charges. (See your Deferred Annuity Contract Provisions.)

7. This withdrawal arrangement can be renewed annually or can continue until revoked. Notification of revocation must be submitted to the Home Office at least 30 days before the annual renewal date.

8. Once payments begin, the payment arrangement cannot be changed until the annual renewal date.

9. Amounts withdrawn will earn interest at a rate established by the Company. This interest rate earned on the decreasing balance is subject to change on the annual renewal date, regardless of the Withdrawal Arrangement elected. NOTE: To obtain the current interest rate, please refer to the Current Interest Rates Bulletin that is distributed monthly with the Newsletter or contact the Client Service Center.

10. To the extent the amount withdrawn from the annuity contract is subject to income tax, this amount is reportable to the Internal Revenue Service (IRS). Additionally, interest earned on the withdrawal arrangement is also subject to income tax and reporting.

11. Withdrawals from annuity contracts prior to the owners age 59½ may be subject to an IRS penalty for premature distribution. Your clients should consult their own tax advisors or the IRS for answers to specific questions they may have about the taxability of payments from annuity contracts.

12. IRS Minimum Distribution requirements apply to tax-qualified contracts for owners who are age 70½ or older. Before establishing or renewing a Withdrawal Arrangement, your clients should consult their own tax advisors or the IRS if they have specific questions regarding these requirements.

Calculating The Payment

The monthly and quarterly factors for amortization payments are as follows:

One-Year Amortization Factors for Withdrawal Arrangements

If a client requests a certain payment amount, multiply the appropriate factor by the requested payment to determine how much should be withdrawn from the annuity.

EXAMPLE*: If a client needs a monthly income of $500, this amount should be multiplied by the amortization factor:

* Based on the monthly factor for 4%.

If the client asks that a certain amount be withdrawn from the annuity, then this amount should be divided by the appropriate factor to determine what the payment will be.

EXAMPLE*: If a client wants $2,000 withdrawn, the withdrawal amount should be divided by the amortization factor to determine what the monthly income will be:

Annuity 1035 Exchange

Written by Hersh Stern Updated Tuesday, October 22, 2024

The replacement of an annuity or life insurance policy; i.e. the exchange of an existing policy for a new one purchased from an insurance company without tax consequences, is called a Section 1035 Exchange. To retain the tax advantages of such an exchange, it must meet the requirements of Section 1035 of the Internal Revenue Code for the transaction to be tax-free. A 1035 Exchange allows the contract owner to exchange outdated contracts for more current and efficient contracts, while preserving the original policy's tax basis and deferring recognition of gain for federal income tax purposes.

Reasons for making a 1035 Exchange:

With stock market and interest rate conditions continually changing, it is possible that an annuity which once was the perfect option for you is no longer. If you are in this predicament it may be possible to upgrade your current annuity to one that better meets your needs without paying taxes on any gains.

What are some of the particular reasons you might choose to upgrade your annuity?

To get a better interest rate, better income guarantees, increased caps for fixed index annuity and for variable products, better subaccount investment options.

It is important to know that while you will not be subject to federal income taxes with a 1035 transaction, you may be subject to surrender fees and penalties imposed by your current insurance company as you make the move to another company's annuity.

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How to avoid income tax on any gains in the "old" contract.

Generally, the surrender of an existing insurance contract is a taxable event since the contract owner must recognize any gain on the "old" contract as current income. However, under IRC Section 1035 when one insurance, endowment, or annuity contract is exchanged for another, the transfer will be nontaxable, provided certain requirements are met.

The IRS has indicated through Private Letter Rulings that it will apply a strict interpretation to the rules. For a transaction to qualify as a 1035 Exchange, the "old" contract must actually be exchanged for a "new" contract. It is not sufficient for the policyholder to receive a check and apply the proceeds to the purchase of a new contract. The exchange must take place between the two insurance companies .

To preserve the adjusted basis of the "old" policy.

Preserving the adjusted basis is preferable in situations in which the "old" contract currently has a "loss" because its adjusted basis is more than its current cash value. The adjusted basis is essentially the total gross premiums paid less any dividends or partial surrenders received. This basis carryover is important when the owner has a high cost basis in the "old" contract.

For example, Jane Smith has a Whole Life policy she purchased 15 years ago. She paid $1,000 annual premium for the last 15 years and has received $5,000 in policy dividends. The policy currently has $6,000 in cash value. Jane's cost basis is $10,000 (15 x $1,000 less $5,000 dividends.) If Jane did not exchange the "old" policy for the "new" one, but rather surrendered it and purchased the "new" policy with the $6,000 surrender value, she would only have a $6,000 basis in the "new" policy. If, however, she exchanges the "old" policy, she will preserve the $10,000 cost basis.

Requirements & Guidelines

The owner and insured, or annuitant, on the "new" contract must be the same as under the "old" contract. However, changes in ownership may occur after the exchange is completed. The contracts involved must be life insurance, endowment, or annuity contracts issued by a life insurance company. These are the types of exchanges which are permitted: from an "old" life insurance contract to a "new" life insurance contract; from an "old" life insurance contract to a "new" annuity; from an "old" endowment contract to a "new" annuity contract; and from an "old" annuity contract to a "new" annuity contract. (Note: An "old" Annuity contract cannot be exchanged for a "new" life insurance contract.)

Two or more "old" contracts can be exchanged for one "new" contract. No limit is imposed on the number of contracts that can be exchanged for one contract. However, all contracts exchanged must be on the same insured and have the same owner. The adjusted basis of the "new" contract is the total adjusted basis of all contracts exchanged. The death benefit for the "new" contract may be less than that of the exchanged contract, provided that all other requirements are met. Face amount decreases within the first seven years of an exchanged may result in MEC status. When the face amount is reduced in the first seven years, the seven-pay test for MEC determination is recalculated based upon the lower face amount.

Under current tax law, contracts exchanged must relate to the same insured. Any addition or removal of insureds on the "new" contract violates a strict interpretation of the regulations. For example, you cannot exchange a single-life contract for a last-to-die contract or vice versa. Under certain circumstances you may exchange a contract with an outstanding loan for a "new" contract. This depends on the guidelines followed by the insurance company with whom the "new" contract is to be taken out. One possibility would be for the loan to be canceled at the time of the exchange. If there is a gain in the contract, cancellation of the loan on the "old" policy is considered a distribution and may be a taxable event. One way of avoiding this result would be to pay off the existing loan prior to the exchange.

We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!

Exchanging a deferrred annuity for an immediate annuity qualifies for tax deferral under IRC Section 1035. However, avoidance of the 10% will depend upon which of the IRC Section 72 exceptions the client is relying upon:

1. Payments made on or after the date on which the taxpayer becomes 59½ will avoid the 10% penalty.

2. Payments that are part of a series of substantially equal periodic payments made for the life expectancy of the taxpayer or the joint life expectancies of the owner and his or her beneficiary will also avoid the 10% penalty.

3. Payments made under an immediate annuity contract for less than the life expectancy of a taxpayer who is under age 59½ probably will not avoid the 10% penalty.

Assignment to Insurer

The transfer of ownership in the old policy(ies) to the new insurer is effected with an irrevocable assignment by the owner to the insurer, with a designation of the insurer as both owner and beneficiary of the old contract. The parties to the exchange will then be: (1) the owner of the "old" contract; (2) the insurer of the "old" contract; and (3) the "new" insurer. The owner makes an absolute assignment of the "old" contract to the "new" insurer by notifying the "old" insurer, in writing. The "new" insurer then surrenders the old policy to the "old" insurer, and applies the proceeds of the surrender to a newly issued contract on the same insured.

The Notice of Assignment and Change of Beneficiary form, as well as the Notice of Intent to Surrender, should make reference to the owner's intention to effectuate a 1035 Exchange. The policy assigned to the "new" insurer will ordinarily have a stated value. Therefore, the "new" insurer receives valuable consideration upon assignment to it of the "old" policy. For this reason, the "old" policy should not be assigned to the "new" company unless a favorable underwriting decision has been made and accepted by the policyholder (this is especially important for life insurance exchanges).

Partial 1035 Exchange of Annuity

While the 1035 exchange rules are clear for someone who closes out their entire account and moves all the money to another company, what are the tax consequences when a direct exchange of only a PORTION of an existing annuity is made from one insurance company to another? How would such a "partial" 1035 exchange be taxed?

The IRS, in Revenue Procedure 2011-38 (effective October 24, 2011) provided new guidance on the treatment of such partial 1035 exchanges of annuity contracts.

First, some background.

Before October 24, 2011, the tax treatment of a partial exchange of an existing annuity contract was governed by Revenue Procedure 2008-24 .

This 2008 rule said that an exchange is treated as a tax-free exchange if there is no withdrawal or surrender out of either contract during the 12 months beginning on the date the partial exchange was completed or the taxpayer demonstrated that one of section 72q conditions or a similar life event occurred between the partial exchange and the surrender or distribution. The conditions in section 72(q) include the taxpayer’s attaining age 59½ or dying or becoming disabled.

Revenue Procedure 2011-38 amended Procedure 2008-24 by liberalizing the conditions for a partial exchange completed on or after Oct. 24, 2011, as follows:

The 12-month period waiting period before a withdrawal may be taken was reduced from 12 months (360 days) to 180 days. In other words, if the proceeds from a partial exchange were used by the second insurance company to set up a multiyear guaranteed deferred annuity or a fixed index annuity, then no withdrawal should be taken from the new contract for at least 6 months (instead of 12 months under the old law).

However, this time limit on withdrawals from a new annuity contract that results from a partial exchange does not apply if the withdrawals are from a newly created immediate annuity contract that was set up for a period of 10 years or more or during one or more lives.

In other words, if the money from the partial exchange was used to purchase a new single premium immediate annuity , then under the 2011 guidance you are permitted to begin receiving monthly income immediately (without having to wait 180 days) as long as your new immediate annuity contract was set up to make payments for your life, or for your life plus your spouse’s life, or for a period of 10 years or longer.

Additionally, the old rule which required one of the section 72(q) conditions be met (or that a similar life event occur) was eliminated in 2011.

Finally, one more point about cost basis under the 2011 rules. The original contract cost basis is to be allocated proportionately between the original contract and the new contract based on the percentage of contract value left in the original contract and the percentage of contract value transferred to the new contract.

Effect of Violating the New Rules

If the partial exchange is disqualified, the amount originally exchanged from the source contract is subject to taxation as a withdrawal from the source contract. That amount would be taxable to the extent of any gain in the source contract, and would generally be subject to the 10% additional tax penalty unless the contract owner were 59½. Both the gain calculation and the contract owner’s age would be determined as of the date the funds were exchanged out of the source contract, not the later date when the 1035 exchange is voided.

Tax consequences of the exchange being voided include:

1. The exchange will be treated as a distribution from Annuity “A”, taxable to the extent of gain in Annuity “A” on the date of the exchange.

2. The money received by Annuity “B” in the exchange will be treated as regular premium.

3. The cost bases in both contracts will have to be adjusted to account for the different treatment.

4. Additional tax reporting will be triggered for one or both companies.

Can A Beneficiary Make a 1035 Exchange of an Annuity After the Owner's Death?

Following a private letter ruling (PLR) from the IRS , annuity beneficiaries may have expanded options with regard to inheritances. Previously, annuity beneficiaries were bound by the decedent’s contract terms. Today, annuity beneficiaries may have the option to exchange their inherited contract for current contracts paying higher rates or offering enhanced features and benefits.

In the past, annuity beneficiaries had only limited options available for managing their inherited asset; annuitize the current contract ‘as-is’ within 12 months or withdrawal the entire account’s cash value within five years. The latter would result in the taxation of any gains.

The recent IRS private letter ruling (201330016) expands current restrictions under Section 1035 to include ‘like’ exchanges that occur following the current contract owner’s death. Now, annuity beneficiaries have an additional option; exchanging their inherited contract for one with better terms (increased internal rates, lower fees, and/or enhanced list of investment sub-account options).

To qualify under this new IRS ruling, the following conditions must be met:

1. The new annuity contract must extend the original contract’s terms

2. The taxpayer will become the new contract owner for purposes of ongoing taxation

3. The new contract must remain an annuity contract

4. The current annuity’s value must be transferred to the new annuity company in its entirety

This expanded option creates new considerations for annuity beneficiaries. As this IRS ruling is relatively new, insurance companies may not yet be willing or equipped to handle such transfers. So, be sure to discuss what types of options are offered as well as fees that will be assessed prior to initiating such as transfer.

More Coverage:

Cornell University IRS - PLR 201330016 IRS - Internal Revenue Code Section 1035

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Comments (28)

Dennis 2015-03-13 16:11:00

Why can't I just cash in my annuity and roll over the money to the new company? I can do that for my IRA. Why can't I do that for an annuity?

Hersh Stern (ImmediateAnnuities.com) 2015-03-13 16:12:32

Hi Dennis-- You can always surrender your contract and use the proceeds to purchase a new annuity on your own. You just won't have the benefit of avoiding the income tax on any gains which may have accumulated in the old contract. The advantage of making a 1035 exchange is that you delay recognizing the gains in the old contract for income tax purposes. But if that's not a problem, by all means, cash it in. In your question you also compared an IRA rollover, which you can do on your own, to an annuity exchange, which must be administered between two insurance companies. You asked why doesn't the IRS allow you to simply cash in your annuity and rollover the proceeds into another one within 60 days similar to the IRA rollover rules? The answer is that a 1035 exchange is very different from an IRA rollover. In an IRA rollover, the full premium or investment amount has never been taxed and is wholly liable for income taxes when you withdraw it in the future. So all monies coming and going between IRAs has the same tax status. Taxes are owed on the full dollar amounts whenever withdrawn. The premium in a non-qualified annuity, however, includes a portion of your "cost basis" (your original investment of after-tax money). It's to your advantage that this dollar amount is reliably tagged as NOT having any future tax obligation. Bottom line, the IRS trusts two insurance companies to keep that accounting, but it doesn't trust you to tell it what portion of your annuity is after-tax money and what portion is still subject to tax. That's why Section 1035 of the Internal revenue Code only permits these exchanges to be made by the insurance companies, not individuals. Hersh

Linda 2015-04-01 13:17:55

Just an FYI to those who wish to 1035 exchange a matured annuity for another: Make sure your exchange is for the full amount! I originally invested $19,000 and my annuity grew over the years. I removed the $19,000 and only exchanged the amount I earned. I was told - by my financial planner - that my original deposit would not be considered taxable income. I came to find out the IRS had other ideas and I owe taxes on the $19k even though that was my original deposit which had already been taxed. This does not seem right. The exchange was entirely between the insurance companies. I received a 1099-R from the original insurance company.

Hersh Stern (ImmediateAnnuities.com) 2015-04-01 13:39:13

Hi Linda- Yes, the rule on annuity taxation can be confusing. While it's true you do not owe income tax on the original $19k, the reason you got the 1099 is that the IRS designates the first monies withdrawn from a deferred annuity to be the GAINS (when there are gains), not a withdrawal from your principal or original premium. This is known as the LIFO rule, for "Last In, First Out." In your case, the FIRST IN money was the $19k after-tax premium you paid for your annuity. After investing $19k, the LAST IN money was the gains or interest you earned each year. So when you asked to withdraw money from the annuity, the IRS considered the "Last IN" money, (i.e., the interest or gains which went into your contract AFTER the initial premium was paid in) to be coming out "FIRST" (i.e., "First Out"). That's why you got a 1099. Even though the $19k amount matched the amount of your original after-tax deposit, tax-wise, the $19k was considered a withdrawal of interest. Hersh

Jen 2015-04-07 13:17:50

I have a whole life insurance policy I'd like to convert. The face amount is $305,000, but the cash-value is roughly $7,000. Will I get the $305,000 or the 7,000?

Hersh Stern (ImmediateAnnuities.com) 2015-04-07 13:32:49

Hi Jen- The face amount of a life insurance policy is the death benefit paid to the beneficiaries when the insured person dies. Up to that point, the cash value of the policy is its stated cash value only (less any policy loans borrowed against the cash value). If you initiated a Section 1035 exchange of your life insurance policy for an annuity, there would be $7,000 to fund the annuity. Most companies will permit you to add premium before the annuity is issued. Hersh

Scott 2015-05-06 12:21:17

I am 53 years old. I have a non-qualified annuity that I began 25 years ago. The total value is $37,000 and the gain on the original amount invested is $19,000. Can I close this annuity and rollover the entire $37,000 into an employer-provided qualified retirement account without paying any penalties or taxes?

Hersh Stern (ImmediateAnnuities.com) 2015-05-06 12:22:23

Hi Scott- The quick answer is no. You can only delay income taxes when closing out a non-qualified annuity if you exchange it for another non-qualified annuity under the Section 1035 Exchange rules. A 1035 Exchange must be from one non-qualified annuity that you own into another non-qualified annuity which you will own. What you proposed was moving money from a non-qualified annuity into a qualified account, and changing the ownership of your annuity from yourself to the corporation's retirement trust. Hersh

John 2015-06-04 16:42:47

I have a fixed annuity in my name only. Could I make a 1035 exchange of my existing annuity to a different company and add my wife?

Hersh Stern (ImmediateAnnuities.com) 2015-06-04 16:43:53

Hi John- The rules which allow you to liquidate your annuity and buy a new one and still not pay income taxes on any gains in your first contract are laid out in Section No. 1035 of the Internal Revenue Code. These are known as the "1035 Exchange" regs. A 1035 exchange must satisfy the "like for like" guideline. This phrase "like for like" has come to mean that the name of the owner and name of the annuitant in the existing contract must be the same in the replacing or new contract. So, if in your existing contract you are the sole owner and annuitant then the new contract will also need to be issued with your name only, to satisfy the 1035 regs. However, once the new contract is issued, your new company may allow you to add or change an owner (or even transfer ownership). This is generally true for deferred multi-year and index annuities. With immediate annuities, some companies will also permit you to add a spouse as a joint "beneficiary" but not as the official joint annuitant. For example, say you owned a deferred annuity in your name only. You 1035 the cash value in your contract to a new company in order to buy a joint life immediate annuity. Since you can't add your spouse as an owner to the new annuity under the 1035 rules, you will still be the sole owner of the new contract. However, you may be allowed to set up a payment option which pays income over both your lifetimes even though the company doesn't refer to your spouse as the joint "annuitant." They may refer to her as a joint "beneficiary." But you will be able to accomplish your goal of creating an income for the two of you. Hersh

Dale 2015-06-12 10:39:25

I have a life insurance policy with $20k cash surrender value. The terms of the contract allow me to designate the cash due on surrender to be paid out in a life annuity. The policy says that a "supplementary contract" will be issued in exchange for the current policy at the time of surrender. Will this qualify for a 1035 exchange?

Hersh Stern (ImmediateAnnuities.com) 2015-06-12 10:49:38

Hi Dale, It sounds like you will be exercising an "annuitization" clause in your current life insurance contract. That should be a tax-free event. But please call your company to confirm this. I'd also suggest that you get annuity quotes from our service or one similar so you can compare your company's life annuity offer with those available from other carriers. If you then decide to buy your annuity from a different company you will be able to make a 1035 exchange of your life insurance cash values to pay for the annuity. This should qualify as a tax-free exchange. -Hersh

Jose 2015-07-24 14:47:33

I'm a little confused regarding the 1035 Exchange rules, and I would love some clarification on the subject. Can someone owning an IRA qualified annuity use a 1035 exchange to change from one existing provider to another one? I understand surrender charges may apply, but I just want to make sure that the 1035 exchange benefit is NOT just for non-qualified to non-qualified, but also for qualified to qualified.

Hersh Stern (ImmediateAnnuities.com) 2015-07-24 14:48:20

Hi Jose- You can liquidate a qualified annuity and transfer the net proceeds to another qualified annuity under the IRA transfer rules. This transaction would not be under Section 1035 of the tax code but under the IRA rules. In the end, you'll be able to accomplish the same purpose, move money from one annuity to another and defer income tax on the gains until you make an outright withdrawal without a further transfer. -Hersh

Joe 2015-12-09 07:18:15

Can the cash value of a whole life insurance policy be used to purchase an annuity? Is the transfer tax free?

Hersh Stern (ImmediateAnnuities.com) 2015-12-09 07:18:48

Hi Joe- The answer is YES and the process is called a "1035 Exchange." -Hersh

Lisandra 2016-01-07 11:58:39

I got quotes for an annuity and have a question about the taxes. My annuity will be funded by another annuity which I wish to annuitize. How much taxes will I pay?

Hersh Stern (ImmediateAnnuities.com) 2016-01-07 12:00:19

Hi Lisandra- It's important to know that the quotes you received at our web site did not take into account that your annuity is being paid for through a 1035 exchange of the cash value of an original annuity. So if your original annuity contains not-yet-taxed gains, those gains will increase the amounts you saw in the "Taxable Portion" column at our website. Our calculation assumed the full premium was after-tax cost basis. If some of the premium is pre-tax money, that portion will need to be taxed as you receive distributions from your new immediate annuity. Hersh

Christie 2016-02-09 14:32:04

Do I need to report a nontaxable 1035 Annuity Exchange on my 1040?

Hersh Stern (ImmediateAnnuities.com) 2016-02-09 14:32:50

Hi Christie, Assuming this was an annuity-to-annuity exchange - then no tax is triggered when all the money in the original contract is transferred between the two insurance companies directly into a successor annuity contract. You may get a notice from the insurance company but I believe the transaction is not reported on a 1040. -Hersh

William 2018-07-18 08:15:58

I purchased a non-qualified annuity five years ago. Last year I exchanged this annuity for one with a different company. I also purchased a new deferred annuity with new money from this new company. For tax purposes do I aggregate these two annuities or is the annuity created from the 1035 exchange on its own and not aggregated with the new annuity?

Hersh Stern 2018-07-18 08:17:31

Hi William, Since both annuities were purchased from the same company in the same calendar year, they are aggregated for purposes of calculating the taxable amount of any distributions. -Hersh

Mary 2018-10-26 09:32:02

I am going to transfer a non-qualified annuity with one insurance company for another non-qualified annuity with a different insurance company. The new annuity will have a lifetime income stream with an interest rate of .052% Q 1: Is this considered a 1035 exchange? Q 2: My current annuity matured 5 years ago and has been just earning interest. I have never touched the interest or principle. Is this still considered an annuity? Q 3: Can I add more after tax money to the new annuity? Thank you for your response

Hersh Stern (ImmediateAnnuities.com) 2018-10-26 10:04:00

Hi Mary, Anytime you're purchasing a non-qualified annuity with the proceeds from another non-qualified annuity it is considered a 1035 exchange. This preserves the tax deferred status. To answer your second question, even if your current annuity is out of its surrender charge period, it is still considered an annuity. The only time it would cease being an annuity is if you completely withdrawal the funds from the policy. Finally, when you are making a 1035 exchange you can add other after-tax (nonqualified) money into the new annuity. Let me know if you have any further questions, I'm happy to help. -Hersh

Brian 2018-11-30 09:25:41

Am I able to convert my whole life ins cash value to a 5 yr certain immediate annuity with the 1035 exchange?

Hersh Stern (ImmediateAnnuities.com) 2018-11-30 09:30:15

Hi Brian, Yes, you can 1035-exchange your life insurance cash value into an immediate annuity. We would be happy to assist you with this process. Just give us a call at 800-872-6684. -Hersh

Andrew 2019-05-21 13:20:40

I have a 3 year fixed interest rate annuity contract which comes to term shortly. I am 83 years old and don't want to annuitize. Can I do a 1035 exchange? Is there an age limitation? My current annuity was created by doing a partial 1035 exchange from a previous contact.

Hersh Stern (ImmediateAnnuities.com) 2019-05-21 13:21:33

Hi Andrew, Most insurance companies will allow you to purchase fixed deferred annuities up to age 85. You would be able to do a 1035 exchange from your current annuity to a new one. You can see our list of fixed deferred annuities here: https://www.immediateannuities.com/deferred-annuities/ -Hersh

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Investopedia / Eliana Rodgers

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code allowing for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind.

Rules may vary by company, but full and partial 1035 exchanges are allowed. Typically, 1035 exchanges between products within the same company are not reportable for tax purposes as long as the exchange criteria are satisfied.

Key Takeaways

• Section 1035 of the tax code allows for tax-free exchanges of certain insurance products.
• Life insurance policyholders can use a section 1035 exchange to trade an old policy for a new one with better features.
• The 2006 Pension Protection Act allows exchanges into long-term care products.
• A life insurance policy can be exchanged for an annuity, but an annuity cannot be exchanged for a life insurance policy.

How a 1035 Exchange Works

A 1035 exchange allows individuals to transfer life insurance, annuities, and endowments to a similar vehicle tax-free . These transfers must be between similar products, such as life insurance for life insurance or a non-qualified annuity for a non-qualified annuity. The 2006 Pension Protection Act (PPA) modified IRC section 1035 to include exchanges from life insurance policies and non-qualified annuities into traditional and hybrid qualified long-term care products.

Under a 1035 exchange, the contract or policy owner cannot take the funds and buy a new policy. The money must be transferred directly. The annuitant or policyholder must also remain the same.

For example, a 1035 exchange from an annuity owned by Joe Sample cannot be exchanged for an annuity owned by Jane Sample or a joint annuity owned by Joe and Jane Sample. The exchange must be reported on the individual's annual tax return using Form 1099-R .

A life insurance policy can be exchanged for a non-qualified annuity, but a non-qualified annuity cannot be exchanged for a life insurance policy.  

The primary benefit of a Section 1035 exchange is that it lets the contract or policy owner trade one product for another without tax consequences. Outdated and underperforming products can be switched to newer products with more attractive features, such as better investment options and less restrictive provisions.

Despite the tax benefits, 1035 exchanges do not absolve contract owners of their obligations under the original contract. For example, insurance companies typically don't waive surrender charges for 1035 exchanges. However, fees may be waived if the owner exchanges one product for another within the same company.

Product owners should compare the features of each policy or contract subject to the exchange and conduct a cost-benefit analysis . The new policy should match an individual's investment goals. Owners should consider the administrative fees and transaction charges, such as withdrawal or surrender charges . The financial institution for the new policy must be assessed on how well it manages its assets, liabilities, and shareholder obligations, if any.

The tax treatment differs for partial exchanges in that a portion of the cost basis is allocated to the new product rather than all of it.

Example of a 1035 Exchange

Joe Sample invested $100,000 (the cost basis) in a non-qualified annuity. Joe took no loans or withdrawals, so the value remains unaffected. Because of poor investment performance, the value of the annuity dropped to $75,000.

Dissatisfied, Joe transfers his funds into another annuity with another company. In this scenario, the original contract's cost basis of $100,000 becomes the new contract's basis, although just $75,000 was transferred.

What Is Not Allowed in a 1035 Exchange?

Transfers between qualified accounts, such as IRAs and 401(k)s, are not characterized as 1035 exchanges. Under a 1035 exchange, the IRS disallows the transfer of funds from the account holder to the institution, exchanges between like-kind accounts where the annuitant or owner on the existing account is not the same on the new account, annuity to life insurance, endowment to life insurance, and annuity to endowment.

Do Individuals Have to Report a 1035 Exchange on a Tax Return?

A 1035 exchange must be reported on a tax return. If the funds are transferred from institution to institution, the transferring company will issue a 1099-R form, recording the amount transferred and a distribution code to denote a 1035 exchange. Although the transaction is reportable, it is not taxable. If the exchange occurs in-house, the financial institution may not issue a 1099-R.

What Is the Difference Between a Replacement and a 1035 Exchange?

A 1035 exchange is a replacement, however, not every replacement qualifies as a 1035 exchange. When an annuity or life insurance policy is exchanged into another annuity, it is a replacement and 1035 exchange. An exchange of an annuity contract for a life insurance policy can be characterized as a replacement but does not qualify as a 1035 exchange. Such transactions are taxable, with gains and losses recognized.

Section 1035 of the Internal Revenue Code allows for the non-taxable exchange of certain insurance products. Allowable exchanges include a life insurance policy to an annuity, an annuity to an annuity, an endowment to an endowment, and a life insurance policy to a life insurance policy. The cost basis of the old policy or contract becomes the basis of the new one, despite losses that have eroded the balance. Policyholders should exercise caution when exchanging one product for another, paying careful attention to forgone benefits, charges, fees, and alignment with goals and objectives.

U.S. Congress, The Joint Committee on Taxation. " Technical Explanation of H.R. 4, the 'Pension Protection Act of 2006,' as Passed by the House on July 28, 2006, and as Considered by the Senate on August 3, 2006 ," Pages 194-195. Download PDF.

Internal Revenue Service. " 26 CFR: 1.1035-1: Certain Exchanges of Insurance Policies: Rev. Rul. 2007-24 ."

Code of Federal Regulations. " 26 CFR 1.1035-1 - Certain Exchanges of Insurance Policies ," Page 143.

Internal Revenue Service. " Instructions for Forms 1099-R and 5498: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. ," Page 2.

Internal Revenue Service. " 26 CFR 1.1035-1: Certain Exchanges of Insurance Policies; Notice 2003-51 ," Page 2-3.

Code of Federal Regulations. " 26 CFR 1.1035-1 - Certain Exchanges of Insurance Policies ."

Internal Revenue Service. " Instructions for Forms 1099-R and 5498: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. ," Pages 2, 15.

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