How to model 1035 exchanges of life insurance and annuity policies

Annuity and life insurance owners that own policies with embedded gains have the ability to transfer those policies for new policies without incurring taxes using a technique known as a 1035 exchange. Life insurance policy owners can exchange their policies for a new life insurance policy or an annuity, while annuity owners are limited to an exchange for a new annuity. 

To illustrate this strategy, users will want to create two scenarios and then compare them: one assuming that the taxpayer simply surrenders the policy for cash, and a second illustrating no realized income and corresponding taxes (reflecting the 1035 exchange). 

In this example, assume that one of the taxpayers in this Married Filing Joint couple  owns a non-qualified variable annuity with $30,000 of gain above basis. If she surrenders the policy, she will realize the $30,000 of gain, with the income showing up in the “Taxable Pensions and Annuities” row:

To illustrate a 1035 exchange of this policy, copy the scenario and remove the Taxable Pension and Annuity information from the new scenario. Note how in this case reducing income from the annuity also decreases taxable Social Security, due to less realized income in the scenario:

Some users may wish to document the underlying strategy in the Field Notes for the “Taxable Pension and Annuity” field in this copied scenario:

Lastly, use the Scenario Comparison tool to compare the scenarios, focusing on the Total Tax differential between the two: