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Question #1 --"I want to move a CD to an annuity for my client. Do I use a 1035?"
Question #2--"I have a client with mega-bucks in an annuity in his pension plan and wants to move it to an IRA annuity. Do I use a 1035?"
Question #3--"My client has an annuity with no surrender charges and wants to buy a single premium life policy. Do I use a 1035?"
Question #4-- "My client and his wife each have their own life policy with good cash values, but they need more coverage in a second-to-die policy. Can I roll both cash values into the new survivorship policy with a 1035?"
Question #5 --"My client has over a hundred thousand in an annuity with no surrender charges left, and wants to roll half to one annuity and half to another. Do I use two 1035 forms?"
Question #6 --"My wife and I have annuities of $2,500 each and want to rollover to an annuity that has a $5,000 minimum premium. Can we use two 1035's and roll them into the same annuity?"
1035's are so common and yet remain one of the most easily misunderstood tools provided by the IRS. Questions like the above are asked daily by agents in the field, and a clear understanding of IRC Section 1035(a) provisions is critical for all licensed agents.
The provisions, as written, state the following: IRC Section 1035(a) provides that no taxable gain, or no taxable loss, will be recognized on policy exchanges IF the exchange is with ordinary life to ordinary life; ordinary life to an endowment policy; an ordinary life to an annuity; an endowment to an endowment; an endowment to an annuity; an annuity to an annuity (fixed or variable).
Further, IRC Section 1035(a) states that the exchange must be "like to like". This has been interpreted by many practitioners as "like" insured (or annuitant) to "like" insured (or annuitant); "like" beneficiary to "like" beneficiary; and "like" owner to "like" owner--in other words, the same as before for all three.
Let us look a little more closely at what IRC Section 1035(a) is all about. 1035 is a powerful tool forged out of the fiery mills of the IRC foundry, and implemented and interpreted by the IRS. The problem seems to be that it was not issued with an Owner's Manual, and no clear guidelines on how to use it. The results are questions such as those posed at the beginning of this article, thus requiring Revenue Rulings and even Private Letter Rulings (PLR) for specific cases.
A ray of light recently broke through (July 21, 1995) in Private Letter Ruling 9542037. This PLR has cleared away a few of the cobwebs, and has made the use of the 1035 tool more understandable and effective. For quite some time (since 1968 when 1035 was written) all diligent life and annuity agents interpreted "like for like" to the Nth degree, in some cases causing unconscionable delays in finally making the rollover. In many more cases, Home Offices interpreted this provision even more severely, creating agent frustration. (This new PLR has been written about and described by a number of writers, such as Stephan R. Leimberg, JD, CLU of Leimberg Associates, Inc. of Bryn Mawr, PA, and Mel J. Massey, JD, CLU associated with such companies as USLIFE Companies.) The "ray of light" is the clear interpretation of the IRS that "like to like" refers to the same insured only.
In this light, let's look at answers to the specific questions posed at the outset:
Answer #1--A CD (or a Mutual Fund, Money Market Account, Savings Account, Stock Account) is not an insurance product and thus not eligible for 1035 treatment. Only insurance products have the benefit of taxable gain deferral.
Answer #2--A Pension Plan account, even if invested in insurance products, does not receive 1035 treatment. Rather, it enjoys another facet of tax deferral, either in a Trustee to Trustee transfer, or Direct Rollover using those proper forms, instead of 1035 forms.
Answer #3--Annuity moneys cannot be rolled into a life insurance policy without tax liability on whatever the annuity earned at the point of transfer. The reason is that the death benefit of a Life policy passes to the beneficiaries free of income tax. This is not the case in the death benefit of an annuity policy. Therefore, you cannot give an annuity a tax break it did not already have by transferring to a life policy. 1035 exchanges cannot be made from an annuity to life (but can be made from a life policy to an annuity without immediate taxation of the gain or loss).
Answer #4--PLR 9542037 was very specific in defining the "like for like" in exchanging single life policies for survivorship policies, in that they violated the "like" insured for the "like" insured. The PLR describes four specific situations, where one spouse exchanges his life policy for a survivorship policy on both spouses, an exchange of single life policies on both spouses both owned by one spouse for a survivorship policy, an exchange for separately owned single life policies for a survivorship policy, and all of the above with a Trust as owner. The IRS stated "1035 does not apply to such exchanges if the policies exchanged do not relate to the same insured." The ray of light shines a little more brightly.
Answer #5--When a 1035 exchange is considered, a good rule of thumb is that it's "all or nothing at all." In other words, partial transfers do not qualify for 1035 treatment. You have to roll it all, or consider the tax consequences of the gain.
Answer #6--The "ray of light" tells us that this is not at all possible since it would violate the "like" annuitant to "like" annuitant. (The same situation occurs in IRA transfers of husband and wife into one annuity. This also is not permissible in a non-1035 IRA trustee to trustee transfer.) Each account has to retain its own identity.
With these clarifications, a 1035 exchange can become the extremely useful tool it was designed to be. This tool offers your clients the opportunity to alter their financial outlook as circumstances inevitably change, and exchange one policy for another without immediate tax consequences. Further, an old, antiquated policy may need some of the new features and benefits that proliferate in more recent annuity policies, and some of the higher interest rates and bonuses. Even though exchanges carry over the cost basis from day one of the original policy, they allow deferral of the tax bite now to sometime later. (Of course, the tax consequence is not forgiven, simply deferred.)
How many clients do you have who are languishing in an ancient, low-earning annuity, with few of the features and benefits you could offer in your annuity portfolio? How many of your clients are out of (or nearly so) the surrender charge years? How many of your clients are in variable annuities with inappropriate investments and need more security? How many of your clients have an annuity with a company in receivership, or close to it? How many of your clients would truly benefit by a 1035 tax-free exchange?
Review the points of this article and see if some sophisticated probing can reveal a few real opportunities for effectively using this tool, now that it has been dusted off and presented in a useful manner. Let's turn those no-no's into Yes, Yeses.
About the Author
Jon E. Tregarthen, CLU, ChFC, has been in the insurance business since 1970. He attained his CLU in 1977 and his ChFC in 1989. He has 8 years experience in pension planning and has been with The Annuity Store since May, 1993. Jon can be reached at (800) 825-6094 between 7:30 AM and 4:30 PM Pacific time.
