Partial 1035 Exchanges

Section 1035 Exchange refers to section number 1035 of the Internal Revenue Code (I.R.C.). This section of the tax law describes the tax treatment when one annuity policy is "exchanged" for a new one. Normally, if you were to liquidate an asset, say, a mutual fund, which had increased in value, into cash, taxes would be owed on the gains even if you reinvested the full amount in a different mutual fund. Congress authorized the IRS under Section 1035 to waive taxes on such gains when an annuity policyholder liquidates his or her contract as long as the cash values are exchanged for another annuity, even if with a different company. So the 1035 exchange waiver gives policyholders an opportunity to switch their accounts from one company to another and not be taxed on the gains.

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 single premium immediate annuity, then the first monthly payment needs to be delayed for 6 months (instead of 12 months under the old law);

The rule which requires one of the section 72(q) conditions be met (or that a similar life event occur) is now eliminated;

Limits on the amount received from an annuity contract involved in a partial exchange do not apply if the withdrawal is from an immediate annuity contract 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 single premium immediate annuity for a minimum of 10-years certain or for life then there are no limits on the amount of each month's annuity payment.

Important Note: Rev. Proc. 2008-24 (described below) was superseded by above rule 2011-38.

Under Section 1035 of the IRC, annuity owners may exchange one annuity contract for another annuity contract and the exchange may qualify as a tax-free exchange. The IRS recently issued Revenue Procedure 2008-24, which alters the subsequent tax treatment of the two annuity contracts (the original contract and the new contract) if the exchange involved is not a full exchange of the original contract. In other words, if all the proceeds in the original contract are not exchanged into one or more acceptable contracts, then this "partial" exchange may not be tax-free under Section 1035.

2008-24 Ruling from the IRS

Revenue Procedure 2008-24 provides that if amounts are withdrawn or surrendered from either contract for a 12 month period beginning on the date the exchange proceeds are received by the recipient company, the partial exchange will be retroactively disqualified unless one of the following events occurs after the exchange and prior to the withdrawal, annuitization, change of ownership or surrender: (Note- When there is more than one owner on the contract, one of the following exceptions must apply to each owner. However, the exception does not have to be the same for each owner.)

  • Owner reaches age 59 ½
  • Owner's death (death claim paperwork)
  • Owner's disability (with doctor's statement)
  • Finalization of owner's divorce (copy of divorce decree will be required)
  • Owner's loss of employment
  • The amount withdrawn is allocable to investment in the contract before August 14, 1982 (this investment, referred to as pre-TEFRA cost basis, carries over on a 1035 exchange)
  • The distribution is from a qualified funding asset within the meaning of Code section 130(d) (think structured settlement annuity)
  • Other “similar life event”

Please note that amounts subject to pre-TEFRA cost basis or from qualified funding assets are not “events” that can “occur” after a particular date. However, the other listed events must occur after the partial exchange in order to avoid disqualifying it. For example, if a contract owner completes a partial 1035 exchange after he or she has reached 59 ½ and then takes a withdrawal from one of the annuity contracts within a year of the exchange, the exchange will be disqualified unless one of the other events has occurred after the exchange or exceptions number 6 or 7 above apply.

Additionally, the IRS has provided no guidance explaining what constitutes a “similar life event.”

This ruling applies to partial 1035 exchanges that are completed on or after June 30, 2008.

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:

  • 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.
  • The money received by Annuity “B” in the exchange will be treated as regular premium.
  • The cost bases in both contracts will have to be adjusted to account for the different treatment.
  • Additional tax reporting will be triggered for one or both companies.

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Important Notice: This information is not intended to be a recommendation to purchase an annuity. You should consult with a financial planner to determine if an annuity is a suitable product in your situation. Also, be advised that tax information published at this site is written to support the promotion of annuities. It is based on limited facts and should not be relied upon. You should consult with your own tax and legal advisors for an opinion about what could or should be done in your particular situation.

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