CHAPTER SIX - DISTRIBUTIONS

 

DISTRIBUTIONS WHILE ANNUITY IS IN THE DEFERRED STAGE

When a deferred annuity is still in the deferred stage, amounts can be distributed from the contract (a) when it is fully surrendered or a partial surrender/withdrawal is made, (b) when a death benefit is paid, and (c) when a loan is made by the insurance company using the security of the contract (when allowed).  When partial surrenders or withdrawals are made such payments are usually in the form of a specified amount per contract provision; or where payments are regularly made at specific intervals—a systematic withdrawal program.

There are a variety of withdrawal and income benefits that have recently been introduced by life insurance companies which, when it is all “boiled down,” are only some hybrid form of partial withdrawals from a deferred annuity or annuity payments from an annuitized contract or immediately annuity.  The federal income tax laws regarding the treatment of annuity distributions differ depending upon how the distribution is characterized, whether “an amount not received as an annuity” (including partial withdrawals), or “an amount received as an annuity (an annuity income payment).  Because some of the newer features have not as yet been addressed specifically by the IRS, rules are still pending and some may be taxed as partial withdrawals, and others taxed as annuity income payments.

 

NON-FORFEITURE BENEFITS

 

NON-FORFEITABILITY

“Non-forfeiture” provisions, or non-forfeitability of an insurance policy or annuity, relates to cash value policies and provides that an insured/annuity holder shall receive the equity in some form, even if the annuity is cancelled.  In a retirement plan it is a vested benefit which is enforceable against the plan.  (Note: Either “non-forfeiture” or “nonforfeiture” is correct) Non-forfeiture cash surrender benefit is an amount in a cash value policy that a policyowner will receive upon surrender of the policy, minus any outstanding loan and accrued interest.  These provisions have been closely regulated by regulatory bodies, and with annuities it is even more so. 

Term life insurance and medical benefit plans, are designed so that if an individual cancels or surrenders the policy, the policy is then terminated with no return of premiums paid (except for various return-of-premium riders, etc.)  With a life insurance policy the policyowner may relinquish the policy for its cash surrender value, borrow from the company with the cash value as being collateral for the loan, or take reduced paid-up or extended term insurance.  Annuities, on the other hand, are designed to return the premium with earnings and there are various methods of returning the premiums and/or earnings, therefore the nonforfeiture benefits are more complex.

The surrender of the cash value of the annuity is regulated by the Department of Insurance, and since taxation of benefits is an important part of an annuity, there are also IRS and Treasury Department regulations regarding the surrender of the policy and distribution of the benefits.

 

 

NON-FORFEITURE PROVISIONS

The California Insurance Code addresses primarily the non-forfeiture provisions of annuities, except for reinsurance, group annuities under a retirement plan or certain deferred compensation plan established or maintained by an employer.⁶⁶

The regulations require that certain provisions be part of an annuity, substantially as follows (or with Department approved exceptions):⁶⁷  

A.  When the payment of considerations under a contract has ceased, or the contract owner has requested in writing, the insurer must provide a paid-up annuity benefit on a plan as stipulated in the contract, and of the value stipulated under the regulations.⁶⁸

B.  If the contract provides for a lump-sum settlement at maturity, or at any other time when the contract is surrendered or prior to the commencement of any annuity benefits, a cash surrender benefit of the designated amount shall be paid by the company in lieu of any paid-up annuity benefit.  With the prior approval of the Insurance Department, the insurer may reserve the right to defer the payment of the cash surrender benefit for a period not to exceed six months after the demand has been made and the contract surrendered.  The insurer must inform the Department of the necessity and equitability to all policyholders of the deferral.⁶⁹

C.  The annuity must contain a statement of the mortality table (if any) and the interest rates that are used in calculating any minimum paid-up annuity, cash surrender, or death benefits that are guaranteed under the contract, together with sufficient information to determine the amounts of those benefits.⁷⁰

D.  The annuity contract must also contain a statement that any paid-up annuity, cash surrender, or death benefits that may be available under the contract, are not less than the minimum benefits required by any statute of the state in which the contract is delivered.  Further, the contract must contain an explanation of the manner in which the benefits are altered by the existence of any additional amounts credited by the company to the contract (as discussed under Variable Annuities), any indebtedness to the company on the contract, or any prior withdrawals or partial surrenders of the contract.⁷¹

Regulations also provide that if there have been no considerations received for two full years and if the contract at maturity pays less than twenty dollars a month, the insurer can terminate the contract by payment in cash of the then present value of that portion of the paid-up annuity benefit, calculated on the basis of the mortality table, if any, and the interest rate specified in the contract for determining the paid up annuity benefit, and by that payment shall be relieved of any further obligation under the contract.

Provisions are made for contracts issued prior to January 1, 2004, so as to bring them up to date with recent legislation.⁷²  On the older contracts, the calculation of the minimum nonforfeiture amount used 3% per annum less withdrawals and partial surrenders or loans.  Contract charges on the older contracts was $30 and collection charge was $1.25.⁷³ 

Minimum Non-forfeiture Values

The minimum values of any paid-up annuity, cash surrender, or death benefits available under an annuity contract shall be based upon minimum nonforfeiture amounts that at any time at or prior to the commencement of any annuity payments shall be equal to an accumulation up to that time, at the rates of interest indicated below, of the net considerations (as hereinafter defined) paid prior to that time, decreased by the sum of all of the following:

(A) Any prior withdrawals from or partial surrenders of the contract, accumulated at the rates of interest (See Interest Determination below);

(B) An annual contract charge of fifty dollars ($50), accumulated at the rates of interest indicated below;

(C) Any state premium tax paid by the company for the contract, accumulated at the designated rates of interest.  (However, the minimum nonforfeiture amount may not be decreased by this amount if the premium tax is subsequently credited back to the company);

(D) The amount of any indebtedness to the company on the contract, including interest due and accrued;

The net considerations for a given contract year used to define the minimum nonforfeiture amount shall be an amount equal to 87.5 percent of the gross considerations credited to the contract during that contract year.

Interest rate determination⁷⁴   

The interest rate used in determining minimum nonforfeiture amounts shall be an annual rate of interest determined as the lesser of 3 percent per annum and the following, which shall be specified in the contract if the interest rate will be reset:

(1) The five-year Constant Maturity Treasury Rate reported by the Federal Reserve as of a date, or averaged over a period, rounded to the nearest one-twentieth of 1 percent, specified in the contract but no longer than 15 months prior to the contract issue date or redetermination date (see (2) below, reduced by 125 basis points, where the resulting rate is not less than 1 percent.

(2) The interest rate shall apply for an initial period and may be redetermined for additional periods.  The redetermination date, basis, and period, if any, shall be stated in the contract.  The basis is the date, or average over a specified period, that produces the value of the five-year Constant Maturity Treasury Rate to be used at each redetermination date.

During the period or term that a contract provides substantive participation in an equity indexed benefit, it may increase the reduction described above to an additional 100 basis points to reflect the value of the equity index benefit.  The present value at the contract issue date, and at each redetermination date thereafter, of the additional reduction shall not exceed the market value of the benefit.  The Commissioner may require a demonstration that the present value of the additional reduction does not exceed the market value of the benefit. Lacking a demonstration that is acceptable to the Commissioner, the Commissioner may disallow or limit the additional reduction.⁷⁵

The rates may be designated by the Insurance Commissioner adopting regulations to implement these  provisions and to provide for further adjustments to the calculation of minimum nonforfeiture amounts for contracts that provide substantive participation in an equity index benefit and for other contracts with respect to which the Commissioner determines adjustments are justified.

Any paid-up annuity benefit available under a contract shall be such that its present value on the date annuity payments are to commence is at least equal to the minimum nonforfeiture amount on that date.  Such present value shall be computed using the mortality table, if any, and the interest rate specified in the contract for determining the minimum paid-up annuity benefits guaranteed in the contract.⁷⁶  

Determining Cash Surrender Benefits

For contracts which provide cash surrender benefits, such cash surrender benefits available prior to maturity shall not be less than the present value (as of the date of surrender) of that portion of the maturity value of the paid-up annuity benefit which would be provided under the contract at maturity arising from considerations paid prior to the time of cash surrender, reduced by the amount appropriate to reflect any prior withdrawals from or partial surrenders of the contract, such present value being calculated on the basis of an interest rate not more than 1 percent higher than the interest rate specified in the contract for accumulating the net considerations to determine such maturity value, decreased by the amount of any indebtedness to the company on the contract, including interest due and accrued, and increased by any existing additional amounts credited by the company to the contract.  In no event shall any cash surrender benefit be less than the minimum nonforfeiture amount at that time.   

In other words, if the annuity pays cash surrender benefits, then the benefits that would be available before the annuity matures cannot be less than the present value of the benefits as of the date of that part of the value of the annuity at maturity that arise from considerations paid in before the cash surrender.  This amount will be reduced by any previous withdrawals or partial surrenders on the annuity.  The present value of the annuity value cannot be more than one percent higher than the interest rate that is specified in the contract used to accumulate the net considerations in order to determine the maturity value—decreased by indebtedness to the insurer, including any interest that is due and accrued, and increased by any existing additional amounts credited by the company to the contract.

In no event can the cash surrender benefit be less than the minimum non-forfeiture amount at that time. 

For contracts which do not provide cash surrender benefits, the present value of any paid-up annuity benefit available as a nonforfeiture option at any time prior to maturity shall not be less than the present value of that portion of the maturity value of the paid-up annuity benefit provided under the contract arising from considerations paid prior to the time the contract is surrendered in exchange for, or changed to, a deferred paid-up annuity. The present value will be calculated for the period prior to the maturity date on the basis of the interest rate specified in the contract for accumulating the net considerations to determine such maturity value, and increased by any existing additional amounts credited by the company to the contract.  For contracts which do not provide any death benefits prior to the commencement of any annuity payments, such present values shall be calculated on the basis of such interest rate and the mortality table specified in the contract for determining the maturity value of the paid-up annuity benefit.  However, in no event shall the present value of a paid-up annuity benefit be less than the minimum nonforfeiture amount at that time.⁷⁸ 

When determining these benefits, in the case of annuity contracts under which an election may be made to have annuity payments commence at optional maturity dates, the maturity date shall be considered to be the latest date for which election shall be permitted by the contract, however, it will not be considered to be later than the anniversary of the contract next following the annuitant's seventieth birthday or the tenth anniversary of the contract, whichever is later.⁷⁹

Any contract which does not provide cash surrender benefits or does not provide death benefits at least equal to the minimum nonforfeiture amount prior to the commencement of any annuity payments, shall include a statement in a prominent place in the contract that such benefits are not provided.⁸⁰

Any paid-up annuity, cash surrender or death benefits available at any time, other than on the contract anniversary under any contract with fixed scheduled considerations, shall be calculated with allowance for the lapse of time and the payment of any scheduled considerations beyond the beginning of the contract year in which cessation of payment of considerations under the contract occurs.⁸¹

When Both Annuity And Life Insurance Benefits Are Provided.

For any contract which provides, within the same contract by rider or supplemental contract provision, both annuity benefits and life insurance benefits that are in excess of the greater of cash surrender benefits or a return of the gross considerations with interest—the minimum nonforfeiture benefits shall be equal to the sum of the minimum nonforfeiture benefits for the annuity portion and the minimum nonforfeiture benefits, if any, for the life insurance portion computed as if each portion were a separate contract.  Regardless of the previous provisions discussed above, additional benefits payable — (a) in the event of total and permanent disability, (b) as reversionary annuity or deferred reversionary annuity benefits, or (c) as other policy benefits additional to life insurance, endowment, and annuity benefits, and considerations for all such additional benefits—shall be disregarded in ascertaining the minimum nonforfeiture amounts, paid-up annuity, cash surrender and death benefits that may be required by this article.  The inclusion of such additional benefits shall not be required in any paid-up benefits, unless such additional benefits separately would require minimum nonforfeiture amounts, paid-up annuity, cash surrender and death benefits.⁸²

 

TAXATION OF DISTRIBUTIONS

The IRS Code considers an assignment or pledge of any part of the annuity’s value or in some cases, the gratuitous transfer, to be a “distribution equal to the value assigned, pledged or transferred.”⁸³  It also provides that some charges, such as for non-annuity benefits, that is imposed against an annuity may be treated as distributions.

The general rule is that the taxpayer is given a tax basis in the contract because the premium/consideration paid for a nonqualified contract are not deductible for income tax purposes.  Regulations refer to that basis as “investment in the contract.”  Technically, the Code defines this investment in the contract as of any date that the aggregate amount of premiums or other consideration paid for the contract before such date, minus…the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under this subtitle of prior income tax laws.⁸⁴

As one would expect, the income tax treatment of a distribution depends greatly upon the way that the taxpayer is allowed to recover his investment from the consideration received.  The Code specifies different types of distributions that have specific income tax treatment:

1. Full surrender,
2. Partial withdrawal,
3. Death benefit,
4. Loan, assignment or pledge, or
5. Other constructive distributions.

Incidentally, the income from an annuity is considered as “ordinary” if it is includable in income for tax purposes, and capital gains or losses are not applicable.

Amounts Not Received as an Annuity & Amount Received as an Annuity

The Code and Treasury Regulations discuss many types of distribution, but basically an distribution is “an amount not received as an annuity.”  The Code states that such an amount is defined as “any amount which (i) is received under an annuity…contract, and (ii) is not received as an annuity, if no [other] provision of this subtitle…applies with respect to such amount.⁸⁵ 

An amount is considered as an amount received as an annuity if it is received on or after the starting date of the annuity, in payable in periodic installments over a period of more than one year from that date, and the total of such amounts payable under the contract is determinable at that specific date.⁸⁶

 

TAXATION OF FULL SURRENDER

Also, any amount that is received, whether single sum or periodic payment, under a contract in discharge of the obligation under the contract that is in the nature of a refund on the consideration paid for the contract—such as a lump sum payment payable at death under a refund annuity—must also be included as ordinary income to the taxpayer to the same extent as a complete surrender or exemption.⁸⁷

The following situations will make the surrender to be treated as if a full surrender had occurred:

1. A lump-sum distribution is made, though not actually received, and the sum becomes payable in full as discharge of the obligation of the insurer under the annuity’s contract and the election is not timely made (as previously discussed regarding constructive receipt doctrine).
2. The owner (individual owner) or an annuity transfers it without full and adequate consideration, in effect making a gift of the contract.

If an annuity is entered into for profit, an ordinary loss is deducted for tax purposes if there is a full surrender of the contract, provided the proceeds of the surrender are less than the investment in the annuity.⁸⁸  However, the deduction will possibly be subject to the 2% floor on miscellaneous itemized deductions on the tax form.

Assuming that the taxpayer is the contract owner, the IRS has ruled that an individual who uses an annuity as a means to assign income will be treated as the recipient of income upon the contract’s surrender.⁸⁹   Other rulings have held that an assignor of income is liable for tax on income assigned to others, even if the assignor has relinquished all rights to such income.⁹⁰ These decisions should be easy to understand as the IRS has taken the position that an annuity owner who has accumulated funds on a tax referral basis within the annuity, uses said annuity to (for instance) pay off a debt, the assignor cannot escape from the taxation on the growth of the fund that has accumulated and on which he has not as yet paid taxes.  The assignor of income is liable for tax on the income assigned to others, even if the assignee has relinquished all rights to that income.  (This is known as the “fruit from the tree” doctrine.)⁹¹

Taxation of a Partial Withdrawal

As a general statement regarding a partial withdrawal from an annuity contact before the annuity starts, the amount that is received by the owner is includible in income for tax purposes.  The income on the contract is the excess of the cash value of the contract immediately before the amount is received over the contract investment.  Surrender charges are not taken into consideration.⁹²

This situation is full of unanswered questions as of this date, as, for example, where there is a two-tiered contact and cash payments are made, an account value of one amount is usually used to determine the dollar amount of periodic payments over extended periods, such as a life annuity, but the account value of a lower amount will be provided if the benefits are paid in a lump-sum.  The higher amount can not be considered as a cash value in determining the income on the contract because the higher amount is not available where the contract is surrendered and the amount taken in a lump sum.  Conversely, the IRS may decide that that the difference between the two is a surrender charge (which is ignored under the Code).

The IRS has determined that in some situations partial withdrawals taken in the form of systematic withdrawals, such as in the case of a death benefit payment, can be considered as annuity payments and so taxed.⁹³

In determining the appropriate taxpayer when there is a partial withdrawal, it is usually looked at as if it were a full surrender and therefore the owner of the contract would be the taxpayer, which includes those situations where the owner has assigned the right to receive the proceeds of a partial withdrawal to a third party.

As a matter of interest, prior to 1982 and the enactment of TEFRA, a partial withdrawal was not included in income until the investment in the contract had been completely recovered, and loans and assignments were not treated at distributions.  But because annuities were being used for short-term investment purposes, the rules were changed as discussed.

The rules are complex and expert advice should be provided in these situations.

 

MULTIPLE CONTRACTS AGGREGATION RULE

There are two situations where annuities must be combined for tax purposes. 

When determining the amount to be included in gross income, when an annuity is surrendered or a partial withdrawal is made, then all annuity contracts issued by the same insurance company to the same policyholder during any calendar year are treated as a single annuity.  Technically, this is the aggregation rule.⁹⁴  Further, all affiliated insurance companies will be treated as one company for such purpose.  It is rather interesting to see why such a rule is determined to be necessary and it can be best explained by example.

Example:  John purchased one deferred annuity contract for $1,000 and after some time, it grew to $1,500.  If John wants to withdraw $300, he would be taxed on the entire $300.  However, if John had bought 10 contracts for $100 each, each annuity had grown to $150, John could then surrender two contracts and would be taxed only on $100—the excess of the amounts that that John received on surrendering the two contracts for $300, over the investment he had in each contract, $200.  The aggregation rule was adopted to address situations of this type but it can also apply in some annuitization situations and following a tax-free exchange.

It should be noted that the IRS may enact other rules to prevent the avoidance of Section 72(e) rules through serial purchases of contracts or otherwise.  However, so far the Treasury Department and the IRS are only “considering” such rules.

Another, older, aggregation rule provides that two or more annuity obligations or elements that are acquired for a single consideration—which can be paid by more than one person and in more than one sum—will be treated as a single annuity contract.  The IRS has ruled that two deferred annuity contracts issued in a tax-free exchange (replacement of an annuity) are treated as a single, aggregated contract for purposes of the Code Section 72.  Therefore, amounts that are distributed from one contract to pay required premiums under the other contract are not treated as distributions taxable under the Code.⁹⁵

 

TAXATION OF A DEATH BENEFIT UNDER DEFERRED ANNUITY

The death benefit may be paid under a deferred annuity either as a “pure” contract provision irrespective of tax laws, or it may be paid to fulfill a Code Section 72(s) requirement.  If the death benefit is paid in a lump sum, the distribution is taxed in the same manner as a full surrender.  However, if the annuity is paid as an annuity option, such as payments made for the life of the beneficiary, the distribution is taxed as an amount received as an annuity.  The IRS has ruled that the payment of death benefit under a deferred annuity as systematic withdrawals which have been determined in a certain manner, can also be taxed as an amount received as an annuity.⁹⁶

This also applies if death benefits exceed the cash surrender value at death, including enhanced death benefits payable under variable annuity contracts.⁹⁷

Conversely, a death benefit paid under a term life insurance rider that is issued in conjunction with an annuity contract may be eligible for exclusions from gross income, but the benefit must be paid under a rider that is economically independent of the annuity and separately constitutes life insurance under IRS regulations.⁹⁸

In estate planning, it should be pointed out that the recipient of a death benefit payment(s) from an annuity contract is eligible in many cases for an income tax deduction related to the value of the annuity contract in the decedent’s estate for federal estate tax purposes.⁹⁹

Taxation of a Loan, Assignment or Pledge of Annuity

The amount of a loan received from an annuity is treated as an amount not received as an annuity and is included in gross income under the “last in, first out” (LIFO) rule, whether the amount is received directly or from another source.

Any portion of an annuity that is pledged, or subject to an agreement to be assigned or pledged, is treated as an amount received as an annuity.¹⁰⁰

In actual practice, only a few nonqualified annuities will allow loans from the issuing insurance company.  An assignment or pledge of an annuity may be used to obtain a loan from a third party, but if so, the contract will be subject to the “amount not received as an annuity” tax.

Constructive Distributions Taxation

Loans, assignments and pledges are considered as distributions from a nonqualified deferred annuity and are so addressed directly by the IRS which has also considered the receipt of certain other benefits in connection with the ownership of a deferred annuity as a “constructive distribution.” 

There are a couple of examples of how this applies.  An annuity contract owner may be taxable on the charges that are imposed for investment advice received by the owner in connection with the annuity contract.  Another example would be if there is a long-term care benefit and the long-term care benefit and the annuity benefit are considered to be provided from separate contacts under state law, then constructive distribution would apply.  If a constructive distribution has deemed to have occurred, then the taxation of the distribution is that of a partial withdrawal.  The ten percent penalty tax may also apply.

 

PENALTY TAX UNDER CODE SECTION 72(a)

The Code^100A provides for a ten percent penalty tax on the taxable portion of distributions from nonqualified annuities, and such tax is imposed on top of the income tax that is otherwise due.  This tax applies unless there is a specific exception.  Most exceptions pertain to distributions, the most common exceptions relate to distributions

1. Made on or after the date that the taxpayer attains age 59 1/2 (if distributions are from a grantor trust, then the grantor of the trust is considered the taxpayer);
2. Made on or after the death of the holder, or the primary annuitant if the holder is not an individual;
3. Attributed to the annuity holder becoming disabled;
4. That are a part of a series of approximately equal periodic payments made for the life of the taxpayer or the joint lives of the taxpayer and his designated beneficiary (“lives” may be life expectancy);
5. Allocated to investment in the annuity prior to Aug 14, 1982; and
6. Under an immediate annuity contract.

These exceptions are said to fall on “premature” distributions from annuities.  The purpose of the penalty tax, as should be obvious by now, is to make sure that nonqualified annuities are principally oriented towards savings for retirement.

Substantially Equal

The exception in respect to “substantially equal” periodic payments is quite important and often applied.  When the exception was first introduced (1982), it was observed that the requirement that the amount be paid out as one of a series of “substantially equal” periodic payments is met whether it is paid as part of a fixed annuity, or as part of a variable annuity under which the number of units withdrawn to make each distribution is substantially the same.  This particular exception has drawn considerable legislation and review and one might say is under the personal guidance of the IRS.  There are even regulations in respect to the “substantially equal” periodic payment requirements where it can be recaptured and under what circumstances.

Some point out that an important interpretation of Code Section 72(q) seems to state that variable annuity payments, which are purposely not equal in amount, would qualify for the exception from the penalty tax for “substantially equal periodic payments.”

 

TAXATION OF ANNUITY PAYMENTS

Amounts Received as an Annuity

Annuity payments in the tax code are described as “amounts received as an annuity” which includes both immediate annuity payments and payments received after annuitization of a deferred annuity.  The “amounts received as an annuity” are taxed more favorably than under the LIFO rule used for partial withdrawals because each payment is treated as if it were part income and part an excludable recovery of the premium that was paid for the contract. 

Technically, amounts that are “received as an annuity” are amounts that are received on or after the annuity starting date under an annuity (or life insurance or endowment) contract payable at regular intervals, over a period of more than one year from the date on which they begin or are deemed to have begin, provided that the total of the amount that is payable (or for variable annuities, the period for which they are to be paid) is determined as of that date.¹⁰¹

The IRS requires that the amount must be determined either directly from the contract terms or from mortality tables and compound interest projections produced by sound actuarial theory.  The IRS has specifically ruled that payments to be made for life to an annuitant are amounts received as an annuity when the annuity starting date can be determined, although the contract owner could alter the length of a permitted surrender period or minimum payment after that date, which would therefore, correspondingly affect the amount of the future payments.¹⁰²

While typically, annuity payments do not include payments such as one-time nonperiodic withdrawals or systematic withdrawals, the IRS has held that in some cases systematic withdrawals paid to a beneficiary of an annuity can be considered as amounts received as an annuity.¹⁰³

Annuity payments can be either fixed or variable and the fixed payments are predetermined and guaranteed over the length of the annuity.  The amount of fixed annuity payments included in income is calculated by multiplying the amount of each annuity payment by an exclusion ratio (described later) until the entire investment in the contract has been recovered, then the entire amount of the annuity payment is included in gross income.

Variable annuity payments are based upon the value of the assets held in the separate account, including any earnings, and as such, are subject to fluctuations.  Treasury Regulations also state that payments may also fluctuate also upon an index or the value of a foreign currency, based upon separate account assets, or foreign currency either in whole or in part.  As stated previously, the Code requirement that annuity payments to be treated as such must be in an amount that can be determined on the starting date of the annuity, does not apply in the case of variable annuities.¹⁰⁴ (The amount of each variable annuity payment included in income is described later.)

Typically, the taxpayer with respect to annuity payments, is the owner of the contract, however if a deferred annuity is annuitized and an annuitant is named different than the one under the contract, then the other party will be considered as the owner for tax purposes, depending upon whether ownership rights have been assigned.  If they have been assigned will depend upon the rules relating to the ownership of property and the assignment of income regulations.  If these rights are transferred in connection with annuitization, the original owner may become taxable on the contract income in existence when the annuitization occurred.

 

EXCLUSION RATIO

Technically, the exclusion ratio (mentioned) above is calculated by dividing the total investment in the annuity as of the starting date of the annuity by the expected return under the contact as of the starting date of the annuity.

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

This ratio is applied then to each annuity payment that is received in order to determine the portion of each payment that is nontaxable.  This ratio continues to be applied unless the duration of the payment obligation is changed, in which case there is a new exclusion ratio calculated. Once the total amount of the investment in the contract has been recovered, the entire amount of each subsequent annuity payment will be included in income.

The investment in the contract represents contributions made to the annuity contract by its purchaser and usually equals the aggregate amount of premiums or other considerations paid for the contract, minus amounts received before the annuity starting date, that were excludable from gross income.¹⁰⁵

The following example may help to understand the exclusion ratio:

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.

Expected Return Element of the Exclusion Ratio

The denominator in the formula above is the expected return under an annuity contract which is the actual or estimated total amount of payments made from an annuity contract.  The expected return depends upon whether the annuity payments are to be made during the life of one or more persons, and whether the payments are made only for a fixed period or amount.

If the duration of the annuity payments depend upon the continued life of one or more persons, such as in a life contingency, then life expectancy is determined by applying the appropriate actuarial tables that are set forth in the Treasury regulations.¹⁰⁶ These tables are used for calculating the amount of the expected return in a variety of situations and, obviously, are quite complicated and require actuarial expertise.

However, if the expected return does not involve life contingencies, then the expected return is determined in one of two ways.

When term certain payments are to be made, then the expected return is the result of multiplying the number of payments (in years or months) by each payment amount.  When payments of an amount certain are to be made, then the expected return is the total amount guaranteed, in which case, if there is excess interest to be paid or credited, the expected return is determined without considering the excess interest, and when subsequent amounts are paid that reflects the excess interest, they are included in income as ”amounts not received as an annuity” after the annuity starting date (which means that they are fully includable).¹⁰⁷

Exclusion Ratio When There is a Refund Feature

When an annuity has an expected return that is based on the life of the annuitant, it is considered to have a refund feature when the contract provides that payments will be made to a beneficiary or the estate of the annuitant, on the death of the annuitant, provided that the payments are an effectual refund of the consideration paid for the annuity.  The value of these refund payments is then subtracted from the investment in the contract in order to determine the exclusion ratio on the starting date of the annuity.  The amount is determined by using the actuarial tables in the Regulations.¹⁰⁸

Life contingent annuities are often purchased with some sort of return feature—such as period certain, installment refund or a cash refund.  Where such a refund is applicable, and the annuitant dies which actuates benefit payments to the beneficiary, the benefit payments are included in income if it is paid in a lump sum, in which case it is included to the extent that it exceeds the unrecovered investment in the contract at that time.  Also, they are included if they are distributed as a continuation of the original annuity payments, in which case they are fully excluded from income until such time that the remaining investments in the contract is recovered, and then all of the annuity payments are fully includible as income.¹⁰⁹

Taxation of Joint Annuity Payments

The amount of the annuity payments included in gross income is determined under the same rules as for a single-life annuity, fixed or variable.  The IRS provides guidance as to the proper mortality tables to be used (joint and last survivor mortality tables) and if the annuity provides for a change in the amount of payments upon the death of one of the annuitants, the Treasury Department has special rules for determining the expected return.¹¹⁰

Policyholder Dividends Received with Annuity Payments

Policyholder dividends that are received on a participating contract on or after the starting date of the annuity are fully includible in the gross income of the recipient and has no effect on the exclusion ratio.¹¹¹ 

Treatment of Variable Annuity Payments

Regulations expect that variable annuity payments will fluctuate so the expected return cannot be determined as accurately at the annuity starting date.  There is a special rule to determine the excludable part of each periodic payment.¹¹²

The regulations treat taxes for variable annuity payments in three stages:

1. The expected return is equal to the investment in the contract, so that the exclusion ratio is thereby, 100 percent.
2. The amount received as an annuity with respect to each payment under the contract and which is totally excluded from income according to definition, equals the part of the investment in the contract that is allotted to the payment period.  This particular part is calculated as the investment in the annuity divided by the number of expected payments.
3. The balance of the payment is fully included in gross income as an amount not received as an annuity after the annuity starting date.

An example helps to better understand this situation:

John purchases a variable annuity for $10,000 premium and chooses a variable payment option that provides for an annual annuity payment for his lifetime.  When John reaches his starting age, he has a life expectancy of 10 years.  The amount that is excluded from taxation from each payment is calculated as the $10,000 investment in the annuity divided by 10 (years), which is $1,000.

The taxable portion is the total amount of the payment minus $1,000—the amount will vary, depending upon the investment performance.  If, therefore, the first variable annuity payment is $2,000, $1,000 will be treated as return of investment in the annuity and is not taxable.  The remaining $1,000 will be included as ordinary income as an amount not received as an annuity after the annuity starting date.

Taxation of Partially Annuitized Deferred Annuity

A partial annuitization occurs when only part of the surrender value is used to provide annuity payments and the income tax treatment is not clear because, in a large part, it will depend upon the form of the annuitization.  Because of the uncertainty of the tax treatment, annuitants should proceed carefully as there just are too many variables.  After considerable regulations and changes in views, the only possibility that may remain is that under Code Section 72(e) that amounts are taxed only if they are received, but unfortunately there is no printed authority as yet.

In one area, when a partial annuitization is structured as an exchange of deferred one annuity for two deferred annuities, followed by the annuitization of one of the contracts, the IRS now has agreed that the exchange of one deferred annuity for two deferred annuities qualifies as a tax-free exchange under Code Section 1035.  However, if this is a tax-free situation, then it follows that the annuity owner should be able to annuitized one of the annuities and the payments would be taxed as amounts received as an annuity.  There is a possibility that the IRS might contend that in this situation, the aggregation rule  applies, even though it is not clear as to what would treatment would result in that case.

Split Annuities

A split annuity or combination annuity is an arrangement in which an immediate and a deferred annuity are purchased at the same time.  Usually in such arrangements the consideration paid is allocated between an immediate annuity for a particular term certain and a deferred annuity, where the cash value is projected to equal the total amount of the consideration at the end of the term of the immediate annuity.  Also in these situations, the tax treatment is not clear, but it would depend upon the application of the aggregation rule.

Some rulings did not consider the aggregation rule as the IRS considered the immediate and deferred annuity elements separate contracts, but this ruling was later revoked with no explanation.  Later rulings stated that although the aggregation rule does not apply to these situations, no inference was to be drawn as to the ability of the Treasury to deal with the treatment of such arrangements through other tax law provisions.  Again a situation where expert advice is needed, plus a crystal ball…

A Surrender Value After Annuitization Starts

An annuity may provide a surrender or commuted value after the annuity payments have started, and the remaining payments would still be taxed as annuity payments.¹¹³

In the rulings, the IRS has held that an annuity contract can provide for a surrender value after annuity payments start, and then the remaining payments will still be taxed as annuity payments.  The IRS does not consider this surrender value to cause the contract owner to be in constructive receipt of the annual interest increments credited to that particular value.

One important item to keep in mind, here, is that the immediate annuities, and in particular life annuities, that provide for surrender values is relatively new and how Code Section 72 applies to them is not really known at this time.  Also, IRS rulings seem to conflict with Treasury regulations which provide for treating a portion of the withdrawal as allocable to the investment in the contract and excluding it from income.  This is another “tread lightly” situation.¹¹⁴

Taxation of Lump Sum Full Payment

A life insurance, endowment or annuity contract that provides for a lump sum settlement as full payment of contract obligations, such as a death benefits, will usually give the recipient the option to receive an annuity in lieu of the lump sum.  The Code (Section 72(h) allows the recipient to include the annuity payments in income rather than including the total amount of the lump sum as income.  However, this election must be made within 60 days after the day the lump sum first became payable.¹¹⁵

Death of the Annuitant Before Entire Amount of Investment is Recovered

If the annuitant dies before the entire amount of investment in an annuity has been recovered, the remaining investment that has not been recovered may be deducted by the annuitant in the annuitant’s last taxable year.  The annuitant is defined, in these cases, as the person receiving the annuity payments.

If the annuity has a refund feature that pays the refund to a beneficiary or the estate of the annuitant after death of an annuitant, the person entitled to the payment receives the deduction for the portion of the investment that has not been recovered.¹¹⁶

 

CHARITABLE GIFT ANNUITY TAXATION

A charitable gift annuity is described as a donation of amount “A,” made by donor X to a charity.  The charity agrees to pay donor X an amount (B) for the rest of donor X’s life.  Since the donation is used to fund an annuity, only a percentage of the donation can be taken as a tax deductible gift in the year of the donation.  This gift is irrevocable.  Since the donor is dependent on the charity to make the income payments, the donor should ascertain the financial ability of the charity to make those income payments.  Thus, such an annuity permits the donor to transfer appreciated property to a charitable organization in exchange for the organization’s promise to pay a continuous stream of income.¹¹⁷.

A part of the amount that is paid in connection with the issuance of the charitable gift annuity must be allowable as a charitable gift deduction.  The IRS usually denies tax exemption for organizations providing “commercial-type insurance” as a substantial part of their activities, but excludes charitable gift annuities from the meaning of “commercial-type insurance.”¹¹⁸

The charitable gift annuity must be the only consideration that is issued in exchange for the property that is transferred by the donor.  Further, at the time of the transfer, the value of the charitable gift annuity must be less than 90 percent of the value of such property.

The charitable gift annuity can be either an immediate or deferred annuity, but it must be payable over a single life or joint lives, not over a period certain.  Further, it cannot include a guarantee feature or provide for any adjustment regarding the amount of the annuity payments by referring to the income received from the transferred property (or any other property)——therefore, it cannot be a variable annuity.¹¹⁹

While a charitable gift annuity is usually backed by the assets of the charity, this does not prohibit the charity from purchasing an annuity contract from a commercial insurer to funds its obligations under the charitable gift annuity and special tax rules may apply, such as requiring (among other things) that the charity possess all incidents of ownership in the annuity and be entitled to receives all payments from the annuity.¹²⁰

Because the charitable gift annuity is, indeed, an annuity, typically the annuity rate in these annuities are lower than the rates paid on a comparable commercial annuity.  The American Council on Gift Annuities provides uniform gift annuity rules that assume that all proceeds of the annuity, or property transferred by the donor will be invested and a maximum of 75 basis points of such proceeds of property will be considered and must be applied as administrative expense.

Income Tax Consequences of a Charitable Gift Annuity

The person making the charitable gift is entitled to a deduction (within limits of IRS Code Section 170) and the gift can take the form of cash or property, including appreciated property.  The amount of the deductible gift is equal to the excess of the fair market value of the transferred property over the present value of the charitable gift annuity.¹²¹

The part of each annuity payment from a charitable gift annuity that is considered as a return of principal is so determined by normal annuity rules.  Therefore, an exclusion ratio is calculated using the present value of the charitable gift annuity as the investment in the contract.¹²²

If the donor contributes appreciated property in exchange for the issuing of the annuity, the return-of-principal part of each annuity payment will consist of the return of the gain that is taxed at capital gains or ordinary income rates, depending upon type of property transferred; and a non-taxable return of basis.

The portion of each payment under a charitable gift annuity that exceeds the return-of-principal element, is taxable as ordinary income.

 

STUDY QUESTIONS

1.  When a deferred annuity is still in the deferred state, amounts can be distributed from the contract when a death benefit is paid, when it is fully or partially surrendered, or

      A.  when the annuity holder needs money for medical expenses.

      B.  when a loan is made by the insurer, using the security of the contract.

      C.  when it is rolled over into an IRA or Roth IRA.

      D.  disbursed to creditors

 

2.  In determining the interest rate used in determining minimum nonforfeiture amounts, it  shall be an annual rate or interest determined as the lesser of a five-year Constant Maturity Treasury Rate by the Federal Reserve, or

      A.  5 percent per annum.

      B.  3 percent per annum.

      C.  10 percent.

      D.  $10,000.

 

3.  A paid-up annuity benefit available under an annuity contract shall be such that its present value on the date that annuity payments are to start, must be

      A.  at least equal to the minimum nonforfeiture amount on that date.

      B.  in excess of the minimum nonforfeiture amount on that date.

      C.  be less than the minimum nonforfeiture amount on that date.

      D.  the face amount of the contract less investment increase on the accumulated premiums.

 

4.  In determining cash surrender benefits, the death benefits under annuity contacts

      A.  shall be at least equal to the cash surrender benefit.

      B.  shall be determined by the probate courts.

      C.  shall be no more than the amount of contributions paid in.

      D.  the cash surrender benefit must be less than the minimum nonforfeiture amount at that

            time.

 

5.  If an annuity contract does not provide cash surrender benefits or provide death benefits at least equal to the minimum nonforfeiture amount prior to the commencement of any annuity payments,

      A.  it would be considered as an endowment contract and taxed accordingly.

      B.  none of the benefit payments will be taxed as ordinary income.

      C.  the annuity period must not exceed three years.

      D.  it must include a statement in a prominent place in the contract, that such benefits are not

            provided.

 

6.  The general rule that a taxpayer is given a tax basis in the contract because the premiums (considerations) paid for a nonqualified annuity are not deductible for income tax purposes, is called

      A.  the investment in the contract.

      B.  minimum nonforfeiture side-sitting.

      C.  basis equalization.

      D.  taxable conversion.

 

7.  Any amount that the annuity holder received upon the complete surrender or redemption of an annuity is included as ordinary income to the taxpayer

      A.  to the extent that the amount received exceeds the investment in the contract.

      B.  on a first-in, last-out basis.

      C.  provided the taxpayer is over age 70 ½ and has had the annuity for more than 10 years.

      D.  unless the taxpayer elects to use capital gains rates.

 

8.  If a lump-sum distribution is made, though not actually received, and the sum becomes payable in full as discharge of the obligation of the insurer under the annuity contract and the election is not timely made, then

      A.  this would be considered as a partial surrender.

      B.  this would be considered as a non-secured loan.

      C.  this would be treated as if a full surrender had occurred.

      D.  the contract would be considered as void ab initio (from the beginning).

 

9.  When, for tax purposes, annuities must be combined for tax purposes if they are issued by the same company to the same policyholder during any calendar year, this is

      A.  the combination of policy requirement.

      B.  total and complete surrender of both policies.

      C.  the policy-separation rule.

      D.  the aggregation rule.

 

10.  In determining the amount of annuity payments to be taxed, the IRS uses the proportion of an annuitized payment that is considered as a return of capital and is not taxed. This is called

      A.  the exclusion ratio.

      B.  the aggregation rule.

      C.  the excess-investment rule.

      D.  the first-in, last-out rule.

 

CHAPTER SIX:

1B     2B     3A     4A     5D     6A     7A     8C     9D     10A