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Difficulty: Very hardAnnuities and Insurance-Based Products

An investor holding a non-qualified variable annuity contract with a cost basis of 100,000andacurrentcontractvalueof100,000 and a current contract value of 150,000 executes a Section 1035 exchange into a new variable annuity. During the surrender and transfer process, the investor receives a direct cash payout of 5,000fromtheoriginalcontract′svalue,withtheremaining5,000 from the original contract's value, with the remaining 145,000 transferred directly to the new annuity contract. Assuming the investor is 62 years old, which of the following statements correctly describes the tax treatment of this transaction?

  1. The 5,000cashpayoutistaxableasordinaryincomeinthecurrentyear,whiletheremaining5,000 cash payout is taxable as ordinary income in the current year, while the remaining 145,000 transfers tax-free under Section 1035.Answer
  2. B
    The entire transaction loses Section 1035 tax-deferred status, causing the full $50,000 of accumulated gain to be taxed as ordinary income.
  3. C
    The 5,000cashpayoutistreatedentirelyasatax−freereturnofcostbasis,reducingtheinvestor′scostbasisinthenewcontractto5,000 cash payout is treated entirely as a tax-free return of cost basis, reducing the investor's cost basis in the new contract to 95,000.
  4. D
    The $5,000 cash payout is completely exempt from income tax because it occurred as part of an approved insurance contract exchange.

Answer

The 5,000cashpayoutistaxableasordinaryincomeinthecurrentyear,whiletheremaining5,000 cash payout is taxable as ordinary income in the current year, while the remaining 145,000 transfers tax-free under Section 1035.
IRS Section 1035 permits the tax-free exchange of an existing annuity for a new annuity contract. However, when an investor receives cash or other non-qualifying property during the exchange (known as 'boot'), the boot is taxable in the year of the exchange as ordinary income to the extent of any gain in the original contract. Because the original contract had 50,000inaccumulatedgrowth(50,000 in accumulated growth ( 150,000 market value minus 100,000basis),the100,000 basis), the 5,000 cash payout is fully taxable as ordinary income. The remaining $145,000 transferred directly to the new contract retains its tax-deferred status under Section 1035.

Step-by-Step Solution

1
Calculate accumulated contract growth/earnings
Accumulated gain = 150,000−150,000 - 100,000 = $50,000
Determines the total earnings subject to ordinary income tax rates before cost basis.
2
Apply Section 1035 exchange boot taxation rules
The 5,000cashreceivedisbootandistaxableuptothe5,000 cash received is boot and is taxable up to the 50,000 gain
Section 1035 allows tax-free exchanges, but cash retained by the contract owner ('boot') is taxable as ordinary income under LIFO rules.
3
Determine tax status of remaining transferred proceeds
The remaining $145,000 maintains tax deferral in the new variable annuity
Direct transfers between annuity providers under Section 1035 preserve tax deferral on non-distributed growth.

Key Concept

Section 1035 Exchange Boot Taxation Rules
Estimated Time:1m 30s
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Topics

Annuities and Insurance-Based Products

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