A policyowner wants to exchange a $50,000 cash-value whole life policy for a non-qualified deferred annuity. Which statement about the tax treatment is correct?

Explanation

Under IRC §1035, a policyowner can exchange a life insurance policy for an annuity (or annuity-to-annuity, or life-to-life) without recognizing the gain at the time of exchange, provided the contracts are owned by the same person and the transfer goes directly from one insurer to another (a '1035 exchange'). Cost basis carries over to the new contract. The statement that the exchange triggers immediate ordinary-income tax on the gain would apply only if the policyowner SURRENDERED the policy and used the proceeds to buy the annuity (a constructive receipt) — not a §1035 direct transfer. The claim that the exchange is permitted only if the new contract is also a life insurance policy is reversed — a life policy CAN exchange to an annuity (one-way only; you cannot exchange an annuity back to a life policy). The 10% early-withdrawal-penalty claim conflates the §72(q) 10% penalty, which applies to taxable annuity withdrawals before 59½, not to a properly executed §1035 exchange.