The Do’s and Don'ts of Taking a 1035 Exchange for a Test Drive
There's only one reason that someone would 1035 exchange their policy. It's if the policy that they're going into is better contractually than the one that they're leaving. It's that simple.
Why would someone 1035 exchange their existing policy?
Let's go back a little bit. A 1035 exchange is from the IRS code Section1035. If you are bored take some time and read it. Section 1035 says that you can transfer one annuity to another annuity and not pay taxes on the gains. It's a nontaxable event when you're using annuities funded with non-IRA money. If it's an IRA setting, you just transfer from IRA to IRA which is also a nontaxable event, but for non-IRA funds, a 1035 exchange is the tax law that allows moving from one annuity to another. But just because you can exchange an annuity doesn't mean you should exchange an annuity. It comes down to the contractual guarantees.
During the application process, we will help you through that, but we'll have to do a side by side comparison of exactly what you own and the contractual guarantees of the current policy to the contractual guarantees of the receiving policy, the new one. That new policy has to be contractually better for that 1035 exchange to go through. The annuity carriers review the suitability of all 1035 exchanges and will reject them if you are leaving more / better benefits on the table. If it doesn’t make financial sense for you the receiving company will reject the 1035 exchange.
Now, some agents will say, "Hey, transfer here for this upfront bonus." That literally in some cases is a misdemeanor, but it should be cause for someone losing their license. Never, ever transfer an annuity from one to another only for the upfront bonus. There are no philanthropists in annuity companies giving money away. They have big buildings and sports arenas for a reason. The upfront bonus is nothing more than the overall contractual guarantee. Don't be swayed by that. Run the numbers and see if moving into a bonus annuity makes mathematical sense.
The bottom line is, should someone 1035 exchange their existing policy to another policy? Only if it's in your best interest and the policy you're going into provides a better contractual guarantee for the goals that you are trying to achieve. It's about you. It's your money.
Now, a question from Jim in Tucson, Arizona. He wants to know “Can you reverse a 1035 exchange”.
You can under the free look provision. There are two unique benefits that annuities only can offer. One is lifetime income. It's the only product in the world that can provide a lifetime income stream that you can never outlive. You can live forever, they're going to pay. The other unique benefit proposition that only annuities and only the annuity industry offer is what's called the free look provision. Think of it as test driving a car. When you go buy a car, you can test drive it. With annuities, once the policy is delivered, you can still get out of that. You can still get your money back. You can still reverse the 1035 exchange.
Now, fixed annuities are regulated at the state level and every state has a specific period of when you have to contact the carrier to get that full refund or reverse that 1035 exchange. It's complicated to reverse a 1035 exchange, but you can under the free look provision. If you miss the free look period, then the 1035 exchange remains in place and you're now under the new rules and new surrender charges, etc. of that new policy. Free look periods vary by state but most range anywhere from 10 days to 30 days. When you receive the policy in your hands the clock starts ticking. What I would encourage people to do, especially in a 1035 exchange, is call the carrier that you're going to and make sure that you're getting exactly what was promised to you and you fully understand the contractual guarantees so that you can move forward with that new policy.
If you find out during that free look period, that you were sold a bill of goods, it's not what you want, or things just changed in your life, you can get your money back with this free look provision. I think it's fantastic. It's very pro-consumer. Yes, you can reverse a 1035 exchange under the free look provision, but you can't procrastinate. You've got to call within the free look period for your state.
Can you 1035 exchange from annuities to life insurance?
No. Section 1035 does not allow tax-free movement of funds from annuities to life insurance. The 1035 exchange rule does allow you to move from life insurance to an annuity.
Under Section 1035, you can transfer cash value life insurance into an annuity and it's a nontaxable event. Now, before you do that, there's got to be a lot of conversation, a lot of analysis, a lot of math done to make sure that you're making the right move.
A situation where that may make sense is, let's say your kids are grown and your house is paid off. You don’t need to cover the mortgage or provide for college for your kids if you die, but you would like to have more monthly income. You could take the cash value of your life insurance policy and move that into a Single Premium Immediate Annuity which would provide a lifetime income stream for you and your spouse. As with all purchases it comes down to what you want the money contractually do and when you want those contractual guarantees to start. If having income now® is more important than a lump sum benefit after you die, then a 1035 exchange from life insurance to an annuity might make sense.
Can you 1035 an annuity to a life insurance policy? No. But you can transfer cash value from a life insurance policy to an annuity if it makes contractual sense for you to do that.
It is true that annuities can provide tax-deferred growth just like your Traditional IRA or 401k type structure. It is also true that an annuity inside of an IRA will not provide “double tax-deferral.” People and advisors that are spewing this obvious nonsense are missing the bigger point. That point is when an annuity is used in an IRA, it's there for the transfer of risk contractual guarantee.