The Internal Revenue Service will allow you to exchange one life insurance policy, annuity or long-term care policy for another, free of any taxes or penalties, as long as you adhere to certain rules on these exchanges, which are known as Section 1035 exchanges. If the transaction qualifies, no reporting isrequired; exchanges that don't meet the guidelines for Section 1035 treatment appear on Form 1099-R and the individual Form 1040.
Ground Rules
To qualify your exchange as a Section 1035, you must surrender your old life insurance policy or annuity for a new one without receiving any proceeds from the transaction. The company issuing the new contract must receive and cancel the old contract, and the prior contract must pay any cash value directly into the new policy. In addition, the annuitant or beneficiary must be the same individual; you can't exchange an old annuity contract for another, for example, with someone else entitled to the annuity payments on the new contract.
Reporting Rules
If a distribution is made to the policyholder, the company making the transaction must report the proceeds on Form 1099-R, "Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts." This is the standard form for reporting distributions from retirement accounts, pensions, insurance contracts and annuities. The IRS also requires reporting of the exchange if the old insurance company canceled a loan as a part of the transaction.
Reporting Waived
The IRS does not require the 1099-R reporting if the policyholder does not receive any proceeds from the transaction under Section 1035 or if he exchanges one contract for another within the same insurance or annuity company. The IRS also requires the company doing the transaction to keep records of the "basis" in the contracts, meaning the amount the policyholder has paid in the form of premiums and as an initial investment.
1040 Reporting
If the exchange is reportable, the insurance or annuity company enters the total value of the life insurance policy or annuity in Box 1 of Form 1099-R, the total premiums paid by the policyholder in Box 5 and "6" as the distribution code in Box 7. If you receive any distribution from the exchange, you report the amount on Line 16 of Form 1040, and the taxable portion of the distribution appears on 16B to join your gross taxable income.
Ø What is a 1035 Exchange?
1035 refers to a provision in the tax code which allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy or annuity policy to another life insurance policy, endowment policy or annuity policy, without creating a taxable event.
This transfer option is a like-kind exchange in which no tax is due at time of transfer.
http://www.law.cornell.edu/uscode/text/26/1035
Ø What types of exchanges qualify for 1035 treatment?
A tax-free section 1035 exchange is the exchange of:
(a) a life insurance contract for another life insurance contract, or for an endowment or annuity contract, or for a qualified long-term care insurance contract;
(b) a contract of endowment insurance for another contract of endowment insurance that provides for regular payments to begin no later than they would have begun under the old contract, or for an annuity contract, or for a qualified long-term care insurance contract; or
(c) an annuity contract for an annuity contract or for a qualified long-term care insurance contract;
(d) a qualified long-term care insurance contract for a qualified long-term care insurance contract.
1099r instructions
Ø Can you explain how a partial 1035 exchange works and how the cost basis is affected?
A partial 1035 exchange is when only part of an existing annuity contract is exchanged for another. For example, if I have one annuity with a value of $10,000 and cost basis of $8,000 and do a 1035 exchange of only half of the policy, I now have two policies with a value of $5,000 and cost basis of $4,000. The contract holder must not take a distribution from either policy for 180 days for the partial exchange to remain valid. If the policy holder takes a distribution in the 180-day window, the policies are aggregated and treated as one for purposes of determining the taxable portion of the distribution.
Ø Can distributions from a nonqualified annuity be rolled over into another annuity tax-free if done within 60-days?
60-day rollovers are not permitted for non-qualified annuities. Only way to transfer one annuity to another is through a 1035 exchange.