6.3 Taxation & 1035 Exchanges
Understanding the tax consequences of non-qualified annuity distributions and the strict suitability requirements for Section 1035 exchanges under FINRA Rule 2330 is essential.
Key FINRA Exam Takeaways
- Non-qualified variable annuities are funded with AFTER-TAX dollars; earnings grow tax-deferred.
- Withdrawals prior to annuitization are taxed on a LIFO (Last-In, First-Out) basis: earnings come out first as ordinary income.
- Withdrawals before age 59½ incur an additional 10% IRS penalty on the taxable earnings.
- Section 1035 Exchange: Allows tax-free transfer from annuity to annuity, life insurance to annuity, but NEVER annuity to life insurance.
- Surrender charges (CDSC) may apply upon early withdrawal or 1035 transfer.
LIFO Taxation of Random Withdrawals
An investor deposits $50,000 after-tax. The contract grows to $80,000 ($30,000 earnings). A $20,000 withdrawal is treated as 100% earnings (LIFO), fully taxable as ordinary income, plus a 10% IRS penalty if under 59½.
Permissible Section 1035 Exchanges
Permissible: Life Insurance -> Life Insurance; Life Insurance -> Annuity; Annuity -> Annuity. Prohibited: Annuity -> Life Insurance (cannot convert taxable retirement funds into tax-free death benefits).
Knowledge Checkpoint • Section 6.3
Which of the following insurance product exchanges is NOT permitted on a tax-free basis under Section 1035 of the Internal Revenue Code?