Partial 1035 Exchanges

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Tax Rules on Partial 1035 Exchanges (From LSW) 2009

The IRS has issued a revenue ruling that affects the tax exempt status of some partial 1035 exchanges. Partial 1035 exchanges from an existing annuity contract to a new annuity contract will not be tax-exempt unless certain conditions are met. The exchange will remain tax-exempt if:

1. No surrenders or distributions occur on either contract in the
12-month period following the exchange;

OR

2. The only distribution taken from the contract is because one of the following occurred during the 12-month period following the partial exchange (premature distribution penalties may still apply):

  • Attained age 59 ½
  • Death
  • Disability
  • The distribution is associated with premiums contributed before August 14, 1982.
  • A life event (such as divorce or loss of employment) occurs between the date of the transfer and the date of the distribution.

Bottom line – if a client makes a partial 1035 exchange and then takes a distribution from or surrenders either contract within the first 12 months following the exchange, but does not meet one of the conditions listed above, the exchange will be considered a taxable event and will be reported to the IRS.

Please Note - Taking distributions in the form of a series of substantially equal periodic payments will qualify for an exception from
§ 72(q), but will not meet the requirement of (2) above to qualify as a partial 1035 exchange.

View partial 1035 info as a web page = http://www.lswemail.com/LSWeNews082709.htm

 

IRS warning about partial exchanges of annuities providing periodic payments under Section 72(t) and 72(q) - 2008

June 30, 2008

The Internal Revenue Service (IRS) released Revenue Procedure 2008-24 earlier this year to provide guidance on how the exchange of part of a nonqualified annuity for another nonqualified annuity will be treated for income tax reporting purposes.

The New Rule
If a portion of the cash surrender value of an existing annuity contract is exchanged for another annuity contract on or after June 30, 2008, the exchange will be treated as an IRC Sec. 1035 exchange, provided:

1) no withdrawals are made from, or received in surrender of, either contract within 12 months of the date funds are received for the new contract, including single premium immediate annuities; or

2) the annuity owner shows that a condition covered by IRC Sec. 72(q)(2)* or any "similar life event" (such as divorce or loss of employment) occurred between the date of transfer and the date of the withdrawal or surrender from either contract.

If the direct transfer and exchange of a portion of an annuity contract for a second annuity contract does not qualify as a tax-free exchange under IRC Sec. 1035 and the rules of Revenue Procedure 2008-24, the direct transfer will be treated as a taxable distribution followed by a cash payment for the second contract.

* The IRC Sec. 72(q)(2) conditions exempting premature distributions from a 10% penalty tax on distributions includible in gross income include the owner reaching age 59½, the owner's death or disability, and distributions allocable to investment in the contract before 8/14/82.

No Aggregation of Annuity Contracts
The IRS will not require aggregation of two annuity contracts that are part of a tax-free exchange under
IRC Sec. 1035 and Revenue Procedure 2008-24, even if both contracts were issued by the same
insurance company.

Clients who are younger than age 59½ and who are taking periodic withdrawals from an IRA or a nonqualified deferred annuity generally should not do a partial rollover or 1035 exchange from the annuity or IRA that is providing the payment stream, because doing so has been deemed a “material modification” by the IRS.  The effect of a “material modification” is that the waiver of the 10 percent premature distribution penalty will usually be revoked from the beginning, and the penalty on all distributions plus interest will be due at the time the partial rollover or exchange is completed.  Without further clarification from the IRS as to whether a full exchange or 1035 would be deemed a material modification, it would generally be wise to avoid any rollovers or 1035 exchanges in these cases.

Background.  Clients who are younger than age 59½ and who wish to take withdrawals from an IRA or nonqualified annuity without incurring the 10 percent premature distribution penalty on withdrawals of gain can take advantage of the periodic payment options under Section 72(t) (for IRA plans) and 72(q) (for nonqualified annuities).  This option requires that payments be calculated using on one of three methods (annuitization, amortization, or required minimum distributions).  All three methods must be calculated over the client’s life expectancy and must continue without material changes for the greater of five years or until the client reaches age 59½.  Vision Plus provides a calculator to help you calculate the amount of distribution required for each of the three methods.

Once a client has begun distributions under either the amortization or annuitization method, he or she can generally instigate a one-time change to the RMD method, which will usually result in a lower distribution.  From that point forward, they must adhere to the required minimum distribution method exactly with no more nor less than is required by the RMD life expectancy table.  Failure to comply usually results in previous exceptions to the 10 percent penalty being revoked from the beginning, and the penalty on all distributions plus interest will be due at the time the partial rollover or exchange is completed.

A recent private letter ruling from the IRS confirms an early Revenue Ruling (cited below) that a partial rollover or exchange from a contract currently making distributions in accordance with Section 72(t) or 72(q) is considered a material change even if the total amount of periodic payments remains unchanged after the partial exchange.  Obviously, this would be a great detriment to your clients who are receiving these distributions.

Accordingly, it is usually unwise to recommend a partial IRA rollover or 1035 exchange of nonqualified deferred annuities for which the client has already started to receive periodic payments under Section 72.  If you have questions, please call  800-373-9697.

Citation.  Section 2.02(e) of Revenue Ruling 2002-62 as addressed in Internal Revenue Bulletin 2002-42 states:  “Thus, a modification to the series of payments will occur if, after such date, there is (i) any addition to the account balance other than gains or losses, (ii) any nontaxable transfer of a portion of the account balance to another retirement plan, or (iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable.”

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