The taxation of annuities has remained functionally the same in recent years, with taxation changes being more applicable to “methods” instead of “instruments.” For example, the rather recent regulations regarding Individual Retirement Accounts (IRA) and the addition of the Roth IRA affects the taxation of the method of accumulating funds, and not whether the underlying mechanism to fund the IRA is taxed differently than previously. However, a note of caution: while annuity products have retained tax advantages through numerous revisions in tax laws and Internal Revenue Service and tax court rulings, both laws and interpretations are subject to change. When the precise details of taxation are important to decisions regarding annuities, professional counsel is imperative. The information in this textbook does not represent legal or professional advice of any kind.
The premiums an individual pays for a nonqualified annuity are not tax deductible for federal income taxation purposes. For a qualified annuity, an Individual Retirement Annuity (IRA), the premiums are deductible according to the rules as described elsewhere. When the IRA owner is also covered by an employer-sponsored retirement plan, the amount of the tax deduction permitted gradually decreases until it reaches zero (when the stipulated adjusted gross income maximums are reached).
Annuities may be used to fund group retirement plans. When these are qualified retirement plans, the premiums, or contribution as they are often called, are tax deductible to the employer who makes the deductions on behalf of employees. A Keogh plan can appear to provide an individual tax deduction when the plan benefits only a sole-proprietor that has no employees. In this case, the effect is the same as an individual’s deduction.
Payments made to qualified annuities are either tax deductible or the amounts used for this purpose are not declared as current income when paying income taxes. For example, an employer’s contributions to a group annuity are not reported as income when the contribution is made. And, while the employer’s contribution to an employer-sponsored IRA must be reported as income, it is “washed out” by the tax deduction the employee takes.
Some states assess state premium taxes on annuity premiums. When this is the case, the purchaser does not pay a separate tax. Instead, the insurance company deducts the correct amount from each premium payment and pays the tax directly to the state. Where state premium taxes apply they generally equal about 2% or 2.5% of the premium. Some insurers pay the premium taxes themselves and do not deduct the taxes from the annuity premiums.
FDuring the accumulation period, qualified or non-qualified annuity values build on a tax-deferred basis, with the interest remaining untaxed until money is withdrawn from the annuity.
As stated earlier, interest paid on deferred annuities is not taxed until annuity funds are withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement, the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined as withdrawals before the individuals age 59½. These tax consequences include current income taxation and an additional penalty tax.
Generally, speaking a distribution occurs when the employment is terminated, the employee retires, or the plan is terminated. However, there is a premature distribution tax of 10%, which is applicable to many distributions from qualified retirement plans. This premature distribution tax is in addition to any income tax due on the distributions.
As with most laws or regulations, there are exceptions. They have been divided into three categories by many accountants and other tax practitioners.
Generally, the first exception(s) treats the reason as to why the distribution was made. Obvious exceptions are death or disability before age 59 ½. The least obvious exceptions are
The second exception(s) allows distributions because of separation of service for any reason, as long as they are in the form of a “Qualifying Annuity.” Basically, a qualifying annuity is an annuity starting at any age and paid in (substantially) equal payments and not less frequently than annually, for the life of the participant and his/her beneficiary. The qualified plan may purchase commercial annuities to satisfy the requirements of this exception. (Does this bring visions of “golden parachutes” funded by annuities?)
The third is the “roll over” discussed briefly earlier. The key words for this exception is “timely” and “fully.” This exception can be lost if it takes more than 60 days for a participant to make up their mind, and if less than the entire plan distribution is rolled into the new IRA or other qualified retirement plan.
There is no specific tax penalty for those who retire after age 59 ½, but there is a reduced benefit in Social Security payments for retiring prior to age 65.
Funds that are paid to a participant at normal retirement age escape taxation only on the funds that they have contributed to the plan. The funds that the employee contributes have been taxed earlier, so are not subject to tax again at retirement.
Distributions can be made either in installments or annuitized.
FDistributions that are made in installments are taxed as ordinary income in the year they are received.
For annuitization, there are separate rules. First, as can be expected, if the person receiving the distribution (the distributee) has not paid any money into the plan (i.e. has no cost basis), then all payments are taxed as ordinary income.
Secondly, if there is a cost basis (i.e. the distributee has paid for part of the retirement plan) and if any distributions are made before the annuity starts, then part of the distribution will be taxed as ordinary income, and part as a “return of cost basis.” In order to determine the cost basis portion of the distribution, the following formula can be applied:
Total amount of previously taxed employee contributions.
Total present value of annuitant’s account balance or accrued benefit.
Lastly, the formula may be used only until the distributee has recovered the entire cost basis. If the distributee/annuitant dies and has not recovered the entire cost basis, then the amount that has not been recovered can be used as a deduction on the annuitant’s last income tax return.
If a person chooses to take the distribution in a lump sum, they can do so and qualify for the favorable tax treatment, but the employee must be at least age 59 ½, or dies, separated from service (common-law employees), or become disabled (self-employeds). The distribution must be 100% of the employee’s account balance/accrued benefit, and further, the entire distribution must be made in one taxable year!
Mention should be made of the TRA ’86 related to those who reached age 50 by 1/1/86, and who elected to receive lump sum distributions on contributions made prior to 1/1/1974. Without going into all of the technicalities of this rule, this allowed for some of them to be taxed on the capital gains basis. These rules do not apply to distributions from tax sheltered annuities.
For those who attained age 50 after 1/1/86, the rules are more pertinent. They cannot have portions of a lump sum distribution on pre-1974 contributions taxed as capital gains as opposed to ordinary income. They lose the right to any income averaging on lump sum distributions before they reach age 59 ½. In addition, under TRA ‘86 there was a 10 year averaging of a lump sum distribution, that was reduced to 5 years, but effective 1/1/2000 even the 5-year averaging will not be available.
This TRA ’86 is discussed here as it is still applicable in certain situations. For example, for an individual retiring at this time, and who has contributed to their retirement plan, there are several choices that reflect the taxation of distributions. The following are some of the choices that may or may not be applicable:
As should be obvious, this is a highly technical area of taxation but if it should arise, it would call for the professional expertise of a highly qualified tax accountant.
This subject has been approached previously, but deserves more detail and some repetition.
Any income tax on an annuity or insurance contract that has been distributed from a qualified plan can be postponed by converting the annuity or insurance contract to a “nontransferable” annuity within 60 days. Current taxation on the qualified distribution can be avoided if it is rolled over into a regular IRA.
Important: The funds must be rolled over directly into the IRA to avoid tax consequences. If the funds are not rolled over directly into the IRA or if they receive the money and then roll it over within 60 days, the taxable portion of this distribution is subject to withholding tax of 20%, i.e. the IRS requires that 20% of the money be withheld in anticipation of income taxes being due on that money. Oh yes, the “distributee” can recover that 20% at the end of the year when the individual income tax is filed. But (and it’s a big “but”) the distributee must pay into the new rollover account (IRA) the total amount. This means that the distributee would have to dig deep into their own pockets to pay the 20% that the IRS is holding, and which the distributee cannot recover until they have filed their next income tax.
If the distributee just deposits 80% of the amount into the IRA, the 20% that is being held in account for the distributee or the IRS will be taxed as ordinary income – even though the distributee only has 80% of the fund. In addition, there is a possibility that the distributee would be subject to a 10% penalty tax.
Once the funds have been deposited into the IRA, taxes will not have to be paid on the rollover until the IRA starts to distribute its assets. Any lump sum distribution will be taxed as ordinary income, and any annuity distributions will be taxed as previously discussed.
A partial distribution to an employee of the funds held in their account may be rolled over into a regular IRA unless (1) the employee reaches age 70 ½, (2) payments will be made for 10 years periodically or for the life expectancy of the employee, or (3) the amounts are not included in the gross income in the absence of the roll over.
The income tax that must be paid on an early withdrawal or surrender is based upon whether or not the cash accumulation value of the annuity is greater than the premiums paid at the time of withdrawal. When the cash value is greater, the so-called interest-out-first rule applies and the withdrawal is taxed entirely as interest to the extent of the cash value excess.
CONSUMER APPLICATION
Billy has paid $15,000 into his annuity which has a present cash value of $20,000.when he decides to withdraw $3,000. The value of the annuity is $5,000 more than he has personally paid in. Therefore, the $3,000 will be subject to taxation as interest.
Billy decides that if he has to pay taxes on his withdrawal, he will have to take out more money in order to purchase what he wants, so he withdraws $6,000. Then the first $5,000 is treated as interest, and the other $1,000 is treated as both interest and principal, with taxes to be paid only on the interest portion of the $1,000.
To reiterate, interest paid on deferred annuities is not taxed until annuity funds are withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement, the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined as withdrawals before the individuals age 59½. These tax consequences include current income taxation and an additional penalty tax.
A penalty tax also applies to early withdrawals from the annuity, taken in a lump sum before age 59 1/2. This penalty, requiring an additional tax of 10% of the withdrawal, applies whether or not the annuity is a tax-privileged retirement plan. However, the tax law lists several specific situations under which the 10% penalty is not assessed even if the withdrawal or distribution begins before age 59½:
In addition, if the withdrawal is not taken in a lump sum, and is paid out in installments, each of about the same amount and paid over the annuitant’s lifetime, the penalty tax is not assessed.
While only a few insurers offer loan options with annuities, it must be understood that a loan from an annuity is treated as the receipt of current income. As a result, the amount of the loan is taxed as income. Besides having to pay income taxes, the annuity buyer also pays interest to the insurer, so loans from annuities are not particularly attractive.
When the annuity liquidation phase begins as scheduled, special tax rules apply to annuity distributions provided the income payments meet the Internal Revenue Code requirements to be considered amounts received as an annuity. The requirements are:
By meeting these requirements each income payment is divided into taxable and nontaxable segments. The part that is considered return of premium is not taxed, but the interest portion is taxed. How the taxable portion is calculated is a function of the “exclusion ratio” discussed in more detail on the next page.
FThe Exclusion Ratio is the proportion of an annuitized payment that is considered as a return of capital and is not taxed.
The exclusion ratio is a percentage determined by dividing all premiums paid for the annuity by the expected benefits:
Total Premiums Paid = Exclusion Ratio
Total Benefits Expected
While some fairly complex rules govern this calculation, the following example describes basically how it works. The IRS provides tables to help determine the expected benefits, using a number called a multiple which is the number of years the annuitant is expected to live (assuming there is only one annuitant). This multiple is applied to the monthly annuity benefit that will be paid and also factors in the age at which the annuitant’s benefits are to begin.
CONSUMER APPLICATION
Tim Foyt has paid $90,000 for an annuity that will pay him $1,000 per month for life beginning at his age 65. The multiple from the IRS table is 20 at age 65 (and would be a different number at other ages). The multiple times the monthly benefit times 12 months equals the expected benefits:
20x$1,000x12 = $240,000
After the expected benefits are calculated, the exclusion ratio is then determined:
37.5% (the exclusion ratio)
This means that of each $1,000 monthly payment Foyt receives, 37.5% or $375 is excluded from taxation. The balance, $625 per month, is taxed as current income. To say it another way, 62.5% of every monthly payment is taxed for this particular person.
The specific numbers that apply to each situation will differ depending upon premiums paid, monthly benefit promised and the age at which liquidation begins. For Joint annuitants, IRS tables take into consideration the life expectancies of both people at their ages when annuity payments start. Once the exclusion ratio is calculated, that same ratio applies to every payment as long as payments are made.
When an annuity has a death benefit payable to a beneficiary, the exclusion ratio still applies under certain circumstances. If the annuitant dies after payments have begun in the liquidation phase, the beneficiary must receive the death benefit in installments, either on the same schedule as the deceased or faster, in order for the exclusion ratio to be used.
Different rules apply if the annuity owner dies before the liquidation phase begins. If the beneficiary is the spouse of the annuity owner, the spouse is permitted to receive payments on the same schedule the deceased would have received them, using the same exclusion ratio.
The exclusion ratio also applies to distributions to beneficiaries other than the spouse if the death benefit is handled in one of these ways:
If, on the other hand, the survivor simply receives the annuity death benefit as a lump sum, taxes are due on the entire amount that represents interest earned. This results in taxes being due currently on a larger amount than is the case when the exclusion ratio applies.
People whose estates at death are va1ued at more than $600,000 must deal with federal estate taxes. The value of the annuity at the time of death must be included in the annuitant’s estate in proportion to the amount the deceased person personally contributed to the premiums that bought the annuity. The value of the annuity is the accumulated cash value to date if the individual dies before the liquidation phase begins. After liquidation payouts have begun, the insurance company determines the value of the annuity at the time the annuitant died.
The determination of how much of the annuity’s value must be included in the estate for federal estate taxation must be made. If the annuitant had paid 100% of the premiums, 100% of the annuity value would go into the estate. On the other hand if the annuitant had paid 50% and someone else had paid 50% of the premiums, only 50% of the annuity value would be included in the estate.
This text addresses the simpler aspects of annuity taxation. Tax laws can be quite complex when a particular type of annuity is used in any given case since different people have a variety of personal, business and financial situations that can affect taxation. Professional counsel is always recommended for determining the tax consequences of financial transactions.
STUDY QUESTIONS
CHAPTER 3
1. The premiums an individual pays
A. for a nonqualified annuity are tax deductible.
B. for a qualified annuity are tax deductible.
C. for a non qualified annuity are taxed when distribution occurs.
2. If a qualified plan is distributed, prior to normal distribution, there may be a premature
distribution tax
A. that is in addition to any income tax.
B. if the employee resigns and then retires after 55.
C. there is a court order in a divorce situation.
3. Distributions, from qualified plans, that are made in installments after age 59 ½
A. are taxed as ordinary income.
B. are not taxed.
C. are taxed as capital gains.
4. Interest paid on a deferred annuity
A. is not taxed.
B. is not taxed until the funds are withdrawn.
C. is taxed each year it is earned.
5. The income tax due on an early withdrawal or surrender is based upon whether the cash
accumulation value of the annuity is
A. the same as the amount paid when the annuity was purchased.
B. is based on the interest earned by the annuity.
C. based on the total value of the annuity at the time of the withdrawal.
6. Interest paid on deferred annuities
A. is not taxed until annuity funds are withdrawn.
B. is tax free.
C. is added to the premiums paid in and is taxed as capital gains.
7. The portion of an annuitized payment that is considered a return of capital
A. is taxed as ordinary income.
B. is the exclusion ratio.
C. is added to the interest portion and is taxed.
8. If an annuity owner dies before the liquidation begins, and the beneficiary takes the death
benefit as a lump sum,
A. taxes are due on the amount that represents interest earned.
B. taxes are due on the entire amount..
C. taxes are due on the amount that is considered original investment.
9. At the time of an annuitant’s death, for estate tax purposes, the value of the annuity
A. will not be considered as part of the estate.
B. would be considered in proportion to the amount the deceased contributed to the original purchase.
C. is that portion of the annuity paid as premiums, and not the interest earned.
10. If an owner of an annuity “borrows” from the annuity
A. it is treated as a return of premiums.
B. the loan is interest free.
C. the amount “borrowed” is taxed.
Answers: 1B, 2A, 3A, 4B, 5B, 6A, 7B, 8A, 9B, 10C