If you or a loved one is either in or about to enter a nursing home and are interested in sheltering your assets and qualifying for Medicaid benefits, a Medicaid Annuity will do just that. A great way to fund a Medicaid annuity is through an IRS 1035 exchange.
A 1035 exchange allows you to replace an existing annuity or life insurance policy that may no longer meet your needs for one that better suits your current situation.
How to avoid income tax on any gains in the "old" contract.
Generally, the surrender of an existing insurance contract is a taxable event since the contract owner must recognize any gain on the "old" contract as current income. However, under IRC Section 1035 when one insurance, endowment, or annuity contract is exchanged for another, the transfer will be nontaxable, provided certain requirements are met.
The IRS has indicated through Private Letter Rulings that it will apply a strict interpretation to the rules. For a transaction to qualify as a 1035 Exchange, the "old" contract must actually be exchanged for a "new" contract. It is not sufficient for the policyholder to receive a check and apply the proceeds to the purchase of a new contract. The exchange must take place between the two insurance companies.
Requirements & Guidelines
The owner and insured, or annuitant, on the "new" contract must be the same as under the "old" contract. However, changes in ownership may occur after the exchange is completed.
The contracts involved must be life insurance, endowment, or annuity contracts issued by a life insurance company.
These are the types of exchanges which are permitted:
- from an "old" life insurance contract to a "new" life insurance contract
- from an "old" life insurance contract to a "new" annuity
- from an "old" endowment contract to a "new" annuity contract
- from an "old" annuity contract to a "new" annuity contract.
(Note: An "old" Annuity contract cannot be exchanged for a "new" life insurance contract.)
How to preserve the adjusted basis of the "old" policy
Preserving the adjusted basis is preferable in situations in which the "old" contract currently has a "loss" because its adjusted basis is more than its current cash value. The adjusted basis is essentially the total gross premiums paid less any dividends or partial surrenders received. This basis carryover is important when the owner has a high cost basis in the "old" contract.
For example, Brenda has a Whole Life policy she purchased 15 years ago. She paid $1,000 annual premium for the last 15 years and has received $5,000 in policy dividends. The policy currently has $6,000 in cash value. Jane's cost basis is $10,000 (15 x $1,000 less $5,000 dividends.) If Brenda did not exchange the "old" policy for the "new" one, but rather surrendered it and purchased the "new" policy with the $6,000 surrender value, she would only have a $6,000 basis in the "new" policy. If, however, she exchanges the "old" policy, she will preserve the $10,000 cost basis.
Can Multiple contracts be exchanged?
Yes, Two or more "old" contracts can be exchanged for one "new" contract. No limit is imposed on the number of contracts that can be exchanged for one contract. However, all contracts exchanged must be on the same insured and have the same owner.
Can a Partial 1035 Exchange of Annuity be done?
Yes, The IRS, in Revenue Procedure 2011-38 (effective October 24, 2011) provided new guidance on the treatment of such partial 1035 exchanges of annuity contracts.
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