You may have heard of this type of transfer or transaction. It is simply a section of the Internal Revenue Code that allows for a tax free exchange of certain life insurance policies and annuity policies for a new policy. Why would one want to do this? Let’s say for example that you have a certain life insurance or annuity policy for several years. If you want to get a new policy to replace the one you have had you may have to pay income taxes on that change. Rather than paying income taxes now you can elect to have the taxes which may be due delayed or deferred to the future by electing to have a 1035 Exchange. This can apply in several situations such as: life insurance to a new life insurance, life insurance to an annuity policy or one annuity to another annuity. The details of each of these are contained in the links on the main services page.
If you have had a life insurance policy for several years which has accumulated cash value it may be your best interest to utilize a 1035 Exchange if you are going to replace that older policy with a newer one that will be accumulating cash value. The Internal Revenue Service will tax you on the cash value if it exceeds the total amount of the premiums you have paid. In other words, if you have paid $20,000 in premiums since the beginning of the policy and if you were to cancel the insurance you would receive say more than $20,001+ you have to report as income that difference and pay taxes on the amount of the gain. However, if you were to follow the proper steps you could defer paying that tax. Another benefit of going through the steps of a 1035 Exchange is most of the time you will have a lower premium on the new policy by transferring the cash value from the first policy to the new policy. The influx of this cash can have the effect of lowering the premiums on the new insurance.
One may wonder when or why would someone convert a life insurance policy over to an annuity? If you find yourself in the situation where you no longer need the life insurance policy you have you do have some options which no one else may have thought of as a choice you have. For example, if you have had a policy for several years which has built up a significant cash value and you no longer need the protection of the death benefit what should you do?
If the cash value is higher than the cumulative premiums you have paid and you cash in the policy, you will have to pay income taxes on that difference. However, if you were to convert that policy to an annuity then you would not have an immediate tax consequence. The taxes would be delayed until you spent that cash on something else. This can be very advantageous especially with the annuities we have available today which offer many advantages which were not in existence just a few years ago.
Another time is if you have had a term life insurance policy for many years and now the premiums are going up and you no longer need the protection of the death benefit you could convert that old term policy and have all the of the life insurance premiums you paid count towards the cost basis of an annuity if you wanted to start an annuity for retirement planning. What this means is if you paid $20,000 in life insurance premiums and now converted that life insurance policy into an annuity and then in later years the annuity had total cash value of say $40,000 of which you had made $20,000 of annuity payments, you would be able to access the entire $40,000 of annuity cash with out any tax consequences. This is because you will have paid a total of $40,000 of premiums, $20,000 while it was a life insurance contract and $20,000 while it was an annuity contract so your total cost of the annuity is $40,000 so you do not have any taxable gain and thus the full amount would be tax free. Please keep in mind that the $20,000 of premiums paid in the term policy did not result in any cash value when you converted it to the annuity it was purely a cost. This idea isn’t for everyone but I have used it for some of my clients who were able to benefit from the premiums paid to their term life insurance policies.
If you have had an annuity for several years and would like to update your annuity you can do so without any tax consequences if you follow the strict guides the Internal Revenue Service has set up. All interest accumulated inside of an annuity has been kept from income taxes. If you were to take the money out you would have to pay taxes on the gain. This gain is the amount of cash in excess of the deposit (s) you made into your annuity. If your goal is to continue to let your money grow and want to do so on a tax favored basis then a 1035 Exchange of you annuity is going to take care of that.
If you no longer need the life insurance coverage and have accumulated cash value more than the total amount of premiums paid in you could elect to do a 1035 Exchange and have the cash value deposited into a Tax Deferred Annuity and not have to pay taxes until you take the money out of the annuity. If you have had a life insurance policy for several years which has accumulated cash value it may be your best interest to utilize a 1035 Exchange if you are going to replace that policy with an annuity. The Internal Revenue Service will tax you on the cash value if it exceeds the total amount of the premiums you have paid. In other words, if you have paid $20,000 in premiums since the beginning of the policy and if you were to cancel the insurance you would receive say more than $20,001 or more you will have to report as income that difference and pay taxes on the amount of the gain. However, if you were to follow the proper steps you could defer paying that tax. This is a great way to defer paying income taxes on money and continue to receive all of the great benefits of a Tax Deferred Annuity. Be sure to contact us for more details and specifics of your personal circumstances.