When your clients roll over a retirement account into an annuity, stay alert. They could lose significant tax benefits if they don’t document their investment in the contract.

Gains realized on surrender of an annuity are taxed as ordinary income, but the entire amount received on surrender might not be taxed, since a taxpayer is entitled to receive their investment in the contract back tax-free.

Keeping track of investment in the contract is simple enough when a person pays premiums out a checking account into the annuity—the total amount of the premiums will constitute investment in the contract. But when a rollover is made from a pre-tax retirement account like an IRA, things get more complicated, and documenting investment in the contract is essential to preserve its tax benefit.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of annuities  in Advisor’s Journal, see Annuity Respect: Earning It! (CC 11-150), IRS Streamlines Partial Exchanges of Annuities (CC 11-153), and GAO Report Touts Annuities in Uncertain Retirement Environment (CC 11-141).

For in-depth analysis of the taxation of distributions from an annuity, see Advisor’s Main Library: A—Amounts Received As An Annuity & B—Amounts NOT Received As Annuities.

The IRS has released guidance [Rev. Proc. 2011-38] that substantially liberalizes the rules for partial exchanges of annuity contracts.

Section 1035 allows a tax-free exchange of an annuity contract for another annuity contract. Congress introduced the tax-free exchange because it recognized that the needs of life insurance and annuity owners change over time and that it would be unfair to tax them when they switched policies to better meet their needs.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For in-depth analysis of Section 1035 exchanges, see Advisor’s Main Library: E – Non-Taxable 1035 Exchange of Contracts. See also, Advisorfyi.com, Income Tax: Partial Annuity Exchanges Under Section 1035

Why is This Topic Important to Wealth Managers? This blogticle discusses a situation that may disqualify a Section1035 exchange. Even though wealth managers may be familiar with the 1035 exchange generally, it is important to discuss the details of particular situations which may affect the tax treatment of certain life insurance and annuity contract exchanges.

If a Taxpayer receives a check from a life insurance company under a non-qualified annuity contract, does the endorsement of the check to a second company as consideration for a second annuity contract qualify as a tax-free exchange under § 1035(a)(3) of the Internal Revenue Code?

Illustration: A, an individual, owned a non-qualified annuity contract issued by IC1, a life insurance company. In 2011, A requested that IC1 issue directly to IC2, another life insurance company, a check as consideration for a new annuity contract to be issued by IC2. A intended the transaction to be treated as a tax-free exchange under § 1035. IC1 refused to do so and, instead, issued a check to A. A did not deposit the check, but instead endorsed it to IC2 as consideration for a new annuity contract. What result?

Generally, gross income includes any amount received as an annuity under an annuity contract. [1] The Code though provides that no gain or loss is recognized on the exchange of an annuity contract for another annuity contract.[2]

As a general matter Section however Section 1035 provides for the non-recognition treatment for taxpayers who have “merely exchanged an [annuity contract] for another better suited to their needs and who have not actually realized gain.”[3] Under, the Treasury Regulations the contracts exchanged must relate to the same insured, and the obligee or obligees under the contract received in the exchange must be the same as those under the original contract.[4]

Certain Revenue Rulings hold that exchanges under Section 1035 are allowed when an insurance contract or annuity, issued by one insurance company, is assigned to a second insurance company in consideration of the issuance of a new annuity contract.[5]

Nevertheless, in the above illustration, there was no actual exchange of annuity contracts; nor did A assign the IC1 contract to IC2; nor was there a direct transfer from IC1 to IC2 of the cash value of the old contract in exchange for the new contract. Instead, IC1 disbursed a check to A, which A, in turn, endorsed to IC2 as consideration for a new contract.

Neither § 1035 nor the regulations make any special provision for the purchase of an annuity contract with amounts distributed to the policyholder under another contract. Accordingly, the amount that A received from IC1 under the first annuity contract is taxable in 2011 to the extent set forth in § 72(e).

Held: If a Taxpayer receives a check from a life insurance company under a non-qualified annuity contract, the endorsement of the check to a second company as consideration for a second annuity contract does not qualify as a tax-free exchange under § 1035(a)(3). Instead, the amount received is taxable to the extent set forth in § 72(e).[6]

Tomorrow’s blogticle will continue to discuss relevant issues related to life insurance and wealth management.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

[2] IRC Sec. 1035(a)(3).

[3] H. Rep. 1337, 83d Cong., 2d Sess. 81 (1954).

[4] See Treas. Reg. § 1.1035-1.

[5] See Rev. Rul. 72-358, 1972-2 C.B. 473; Rev. Rul. 2002-75, 2002-2 C.B. 812.

[6] See Rev. Rul. 2007-24.