By Marc Gilman
(800) 927-9326 |
Key Takeaways
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A Section 1035 exchange lets you move life insurance cash value into an annuity without triggering current tax on the policy’s gain.
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If an outstanding policy loan is paid off, or “extinguished,” as part of that exchange, the forgiven amount is treated as taxable “boot” — taxed as ordinary income up to the extent of the gain.
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Annuities generally aren’t set up to carry a policy loan forward the way a replacement life insurance policy can, so paying off the loan with outside funds before the exchange is typically the only clean way to avoid boot.
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The exchange also needs to keep the same owner from start to finish, and the funds should move directly from one carrier to the other.
If you no longer need the death benefit on an old cash-value life insurance policy and want to convert it into retirement income, a Section 1035 exchange into an annuity can be a useful move — the policy’s gain moves over without being taxed today. But if there’s a loan on that policy, the mechanics change, and getting them wrong can turn a tax-free exchange into a tax bill you weren’t expecting.
What Is a 1035 Exchange, and Why Would You Use One?
Section 1035 of the tax code allows certain insurance contracts to be exchanged for another, similar contract without recognizing the built-in gain at the time of the swap. A life insurance policy can be exchanged for another life insurance policy, or for a non-qualified annuity, without current tax — the gain carries forward into the new contract’s cost basis instead of being taxed immediately.
This matters because the alternative — simply surrendering the policy for cash and then buying an annuity with the proceeds — is two separate, fully taxable events. You’d owe ordinary income tax on the entire gain in the policy the year you surrendered it, even if every dollar went straight into a new annuity.
What Happens to an Outstanding Policy Loan in an Exchange?
If your policy has no loan, a direct 1035 exchange into an annuity is generally straightforward: the funds move carrier-to-carrier, and the gain transfers with no tax due at the time.
A loan complicates that. When an exchange happens, any outstanding loan on the policy typically has to be resolved one way or another — either paid off before the exchange, or, for a life-to-life exchange, carried forward onto the new contract. If the loan is simply discharged as part of the transaction — meaning the insurer uses part of the policy’s value to pay it off on your behalf — the IRS treats that discharged amount as if you received it in cash.
What Is “Boot,” and How Is It Taxed?
That discharged loan amount is called “boot” — cash or debt relief received as part of an otherwise tax-free exchange. Boot is taxed as ordinary income, on a gain-first basis, up to the lesser of the boot received or the total gain in the old policy.
Example. Suppose you own a whole life policy with $180,000 of cash value, $110,000 of cost basis (premiums paid), and a $30,000 outstanding loan. Your gain in the policy is $70,000 ($180,000 minus $110,000). If that $30,000 loan is discharged as part of a 1035 exchange into an annuity, the full $30,000 is taxable as ordinary income in the year of the exchange, because your $70,000 gain is larger than the $30,000 of boot. Had your gain instead been only $20,000, just $20,000 of the boot would have been taxable — the lesser of the two figures.
Why Doesn’t the Loan Just Carry Over Into the New Annuity?
For a life-to-life exchange, there’s sometimes a way around this: if the new policy assumes an identical loan and cash value, nothing is “discharged,” and the exchange can remain fully tax-free. Some insurers even offer policies built specifically to accept an incoming loan for this purpose.
That option generally isn’t available when the destination is an annuity. Annuities aren’t typically structured to carry a policy loan the way permanent life insurance is, so there’s usually no “new loan” for the old one to roll into. In practice, that leaves one clean path: pay off the loan with funds from outside the policy before initiating the exchange. Because those dollars didn’t come out of the policy itself, repaying the loan this way isn’t treated as a withdrawal and doesn’t create boot.
What Does This Look Like in Practice?
Using the same example above, here’s the difference repayment timing makes:
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Loan discharged during the exchange: $30,000 of boot, taxed as ordinary income in the year of the exchange, reported on a 1099-R.
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Loan paid off beforehand, with outside funds: No boot. The full $150,000 net value moves into the annuity, and the $70,000 gain carries forward into the annuity’s cost basis instead of being taxed now — taxed later only as it’s withdrawn.
The second path defers the entire tax liability rather than accelerating part of it. If you don’t have the cash on hand to pay off the loan outright, even reducing the loan balance beforehand, or exploring the restructuring and partial-surrender options available on the life insurance side, can reduce how much boot ultimately gets triggered.
What Else Can Break a Tax-Free Exchange?
A few other requirements are easy to overlook:
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Same owner throughout. The exchange has to run from the current policy owner to the same owner on the new annuity. Changing ownership mid-exchange — to a spouse, for example — breaks the tax-free treatment and can also raise gift-tax questions.
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Direct transfer, not a check to you. The funds need to move carrier-to-carrier. If you take a distribution yourself and then buy the annuity, that’s a taxable surrender followed by a new purchase, not a 1035 exchange.
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It’s still reported. Even a clean, boot-free exchange generates a Form 1099-R, with $0 in the taxable-amount box and a distribution code marking it as a tax-free exchange. It still needs to be entered on your return.
Where Does Insurance Planning Fit In?
Converting an old life insurance policy you no longer need for its death benefit into a source of retirement income is a legitimate and often smart strategy — but a loan on that policy is exactly the kind of detail that can turn a straightforward exchange into a tax surprise if it’s missed. Before initiating any exchange, it’s worth reviewing the policy’s current loan balance, cost basis, and cash value together, so the exchange can be structured to actually achieve what you’re hoping for.
What To Do Next
If you’re considering exchanging life insurance cash value into an annuity and there’s a loan involved, we’re happy to help you review the numbers before you move forward.
Phone: (800) 927-9326 Email:
Kitces.com, “Using 1035 Exchange To Turn Unneeded Life Insurance Policy To Annuity”; Kitces.com, “How To Rescue A Life Insurance Policy With A Loan”; Internal Revenue Service, Notice 2011-68; Treasury Regulation 1.1031(b)-1(c).
