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.
Partial Exchanges of Annuity Contracts
Partial exchanges were initially approved of by the Tax Court case, Conway v. Commissioner [111 T.C. 350 (1998)]. There, the Tax Court ruled on a direct exchange—carrier to carrier—of part of an annuity contract for another annuity contract with a different carrier. These types of exchanges are referred to as partial exchanges.
In a partial exchange, the basis and investment in the contract associated with the first contract immediately prior to the exchange is allocated ratably between the old contract and the new contract. Basis and investment in the contract are divided between the contracts based on the percentage of the first contract’s cash value that is transferred to the new contract.
If, for example, John owns an annuity in which he has investment in the contract of $1,000 and has a basis of $500 in the contract, an exchange of half the cash value of the contract for a new annuity contract will transfer half of John’s investment in the contract, $500, and half his basis in the contract, $250, to the new contract. The portion of the old contract that is not exchanged will retain $500 in investment in the contract and $250 in basis.
Initial Guidance on Partial Exchanges
The IRS provided a procedure for partial exchange of an annuity contract in Rev. Proc. 2008-24. Under this guidance, a transfer is tax free only if the contract owner doesn’t withdraw any money from, or receive any money in surrender of, either of the contracts involved in the exchange during the twelve month period beginning with the date of transfer.
The rule doesn’t apply to amounts withdrawn from the annuity under the exceptions to the premature distribution rules of Section 72. For example, these are distributions made: (1) after the taxpayer turns 59½; (2) on or after the taxpayer’s death; and (3) as part of a series of substantially equal periodic payments.