6.12 Tax-Free Exchanges of Insurance Policies
These exchanges of insurance policies are considered tax free:
- Life insurance policy for another life insurance policy, endowment policy, or an annuity contract.
- Life insurance policy, an endowment policy, or an annuity contract for a qualified long-term care policy
- Endowment policy for another endowment policy that provides for regular payments beginning no later than the date payments would have started under the old policy, or in exchange for an annuity contract.
- Annuity contract for another annuity contract with identical annuitants.
These exchanges are not tax free:
- Endowment policy for a life insurance policy, or for another endowment policy that provides for payments beginning at a date later than payments would have started under the old policy.
- Annuity contract for a life insurance or endowment policy.
- Transfers of life insurance contracts where the insured is not the same person in both contracts. The IRS held that a company could not make a tax-free exchange of a key executive policy where the company could change insured executives as they leave or join the firm.
Planning Reminder
Endorsement of annuity check for another annuity is taxable.
Cashing out a commercial annuity or nonqualified employee contract and investing it in another annuity does not qualify as a tax-free exchange. The IRS denied tax-free exchange treatment to a taxpayer who tried to complete a direct exchange of a non-qualified annuity contract but was foiled by the insurance company holding the contract. The taxpayer had asked the insurance company to issue a check directly to another insurer as consideration for a new annuity contract, intending the transaction to be treated as a tax-free exchange under Section 1035. The insurer refused and instead issued a check to the taxpayer. The taxpayer did not deposit the check, but instead endorsed it to the second insurance company to obtain the new annuity contract.
The IRS ruled that endorsing the check over to the second insurance company as consideration for the new contract was not a tax-free exchange. Instead, the taxpayer had to include in gross income the portion of the check that was allocable to income on the contract. If this had been a tax-sheltered 403(b) annuity or a qualifed employee annuity, a distribution from the policy could have been rolled over tax-free to another such annuity, or even to another eligible retirement plan such as an IRA or qualified employer trust. However, in the case of a non-qualified annuity, there is no rollover provision for amounts distributed from the contract.
Note: Tax-free exchange treatment may be allowed if you surrender an annuity contract or insurance policy of an insurer in serious financial difficulty, and roll over the proceeds in a new policy or contract with a different insurer; see the Planning Reminder on this page.
IRS scrutiny of partial exchanges of annuity contracts.
The IRS has been concerned that a direct transfer of a portion of the cash surrender value of an existing annuity contract for another annuity contract, followed by a withdrawal from or surrender of either the surviving annuity contract or the new contract, could be used to reduce the tax on earnings that would otherwise be due on a non-annuity distribution. The IRS has guidelines for determining whether the direct transfer of a portion of the cash surrender value of an existing annuity contract to another contract is a tax-free exchange. The rules apply whether or not the two contracts are issued by the same or different companies. If tax-free treatment is allowed under the following guidelines, the two annuity contracts will be treated separately and the IRS will not require that they be aggregated even if the same insurance company issued both.
For transfers completed before October 24, 2011, Revenue Procedure 2008-24 treats the direct transfer as a tax-free exchange if there is no withdrawal from or amount received in surrender of either contract in the 12 months beginning with the date of transfer. Tax-free exchange treatment is also allowed if, as of the date of the withdrawal or surrender, the taxpayer meets one of the penalty exceptions for pre-59½ annuity distributions, such as being disabled, or the taxpayer is experiencing another similar life event such as divorce or unemployment. However, this favorable rule does not apply to the penalty exceptions for distributions that are part of a series of substantially equal payments or are under an “immediate” annuity. A transfer that does not qualify under the guidelines is treated as a distribution that is taxable to the extent of the earnings in the contract, followed by a payment for the second annuity contract.
For transfers on or after October 24, 2011, Revenue Procedure 2011-38 allows tax-free exchange treatment for a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract if no amount, other than an amount received as an annuity for 10 or more years or during one or more lives, is received under either the original or new contract during the 180-day period starting on the transfer date. If the 180-day test is not met, the IRS will determine if the amount received under either contract within the 180 days should be treated as a distribution taxable to the extent of earnings, or as boot (6.3) in a tax-free exchange.