1099-R for Life Insurance withdrawal

[kgg2]

I changed my life insurance policy from one company to another  in 2023.

Steps:

1.  withdrew $25,000 as a partial surrender. my cost basis was $31,130, so everything showed this would be non taxable.

2. Did a 1035 exchange to the new life insurance for the remaining $40,493, remaining cost basis was 6,130.

Old account was closed, new policy was created.

when i got my 1099-Rs, they show this:

1,  Box 1 - 25,000,     Box 2a 25,000 , Box 7 codes are 7D.  Nothing anywhere else

2.  Box 1 40,493, box 2a 0.00, Total distribution checked, Box 5  6,130, Box 7 Codes 6

After questioning my old insurance company multiple times about why the 25,000 is showing as taxable,  their response is basically this:

Since i did both the partial surrender (25,000) and the 1035 exchange in the same year, that makes the 25,000 taxable.  This is not based on an actual tax code, but a 'Non Authoritative guidance'.

So my question is , is this correct? is it taxable now?  And if it is, shouldn't the cost basis have stayed at 31,130?  That makes a difference on any future withdrawals i may need to make and whether the money is taxable.

[dmertz · Accepted solution]

Your original assumption that the distribution of the $25,000 was nontaxable is incorrect.  This distribution came first from income on the contract (investment gains), so with only $31,130 of investment in the contract (cost basis) and $40,493 remaining balance in the contract, the entire $25,000 came from taxable earnings, correctly reported on the code-7D Form 1099-R (and this is from the tax code, section 72(e)).

Because none of the investment in the contract was included in the $25,000 distribution, the 1035 exchange should have moved to the new contract all $31,130 of your investment in the original contract, so I think that the $6,130 in box 5 of the code-6 Form 1099-R is incorrect and should be $31,130.  This doesn't affect your tax return since the entire 1035 exchange is nontaxable, but it could mean that your new contract shows an incorrect investment in the contract.  You'll want to investigate that with the insurance company(s).  It's certainly incorrect that $25,000 of your investment in the contract simply vanishes.