Annuities are used in all types of tax-favored retirement plans maintained by employers for the benefit of their employees, principally Qualified plans (401(k), tax-qualified defined benefit plans, 412(i) plans and employee stock ownership plans), governmental 457(b) plans and Section 403(b) arrangements. Individual retirement arrangements (IRAs) are also considered workplace retirement plans, such as SEPs and SIMPLEs, which will be discussed in the following section.
The Internal Revenue Code, in attempting to encourage employers to establish and maintain retirement programs for their employees, provided preferential treatment with taxes that would affect favorably workplace retirement plans. As with any such plans, there are requirements.
There are differences between the plans, however all tax-favored plans have limitations on the contributions or the benefits that are made on behalf of any plan participant. Primarily, and this runs throughout tax rules and regulations
F on qualified plans, the use of benefits must be restricted to retirement purposes.
In addition, some tax-favored plans require minimum coverage and nondiscrimination rules which are intended to ensure that the plan covers a cross-section of the employees (not discriminatory) and provides meaningful benefits to covered employees. The types of plans used by employers usually are attributable to their type of business.
Section 403(b) arrangements (tax-sheltered annuities) may only be maintained by employers that are exempt from income taxes, and state and local government schools.179
Governmental 457(b) plans may only be maintained by state and local governments.180 and they differ from tax-exempt 457(b) plans. Tax exempt plans are a type of nonqualified deferred compensation plan maintained by non-governmental tax-exempt entities, most notably charities and private universities. Government 457(b) plans are a type of tax-favored retirement plan.
Tax-qualified plans can be sponsored by all employers as a general rule, however state and local governments cannot maintain a 401(k) plan. A 401(k) plan is a qualified plan that permits employees to make pre-tax salary reduction contributions (the employee can elect to have salary reduced in exchange for an employer contribution which must be equal to the reduction in salary).181
Section 403(b) plan arrangements and governmental 457(b) plans are similar to 401(k) plans as they permit employees to make salary reduction contributions and all three plans receive the same preferential tax treatment.
Normally, contributions to a tax-qualified plan, Section 403(b) or governmental 457(b) plans are excluded from an employee’s gross income and most state income tax laws if the contributions satisfy certain conditions and limits, and the earnings that are credited to the employee under the plan, accumulate on a pre-tax basis. Contributions and earnings become taxable only when they are distributed, but once they are distributed, these amounts are taxable as ordinary income (unless they are rolled over to an IRS, a qualified plan, a Section 403(b) program or governmental 457(b) plan).
NEW! As of January 1, 2006, a qualified plan or a Section 403(b) plan (not a governmental 457(b) plan) may allow employees who make salary reduction contributions to designate some or all of the contributions as Roth IRA contributions. This means that the earnings credited to the employee and attributed to the Roth contributions accumulate tax-free. However, a distribution of an amount attributable to the specified Roth contributions, which includes earnings, is entirely excluded from the employee’s gross income under the IRS Code and most state laws. Distributions that attributable to Roth contributions are tax-free in most cases. If, for instance, the taxpayer is in the same tax bracket at all times and tax rates do not change, then there is no real difference between the tax treatment of a pre-tax contribution and a Roth contribution, with the exception that a Roth contribution produces a larger ultimate benefit than would a pre-tax contribution of the same amount.
Primarily, the laws applicable to tax-favored retirement plans are part of the Employee Retirement Income Security Act of 1974 (ERISA) and the Tax Code. State laws do not usually apply to ERISA-covered employee benefit plan as ERISA usually preempts all state laws that relate to ERISA plans, except ERISA does not preempt state insurance, banking or securities laws, even if they do relate to an ERISA plan, therefore state laws will apply to an annuity used in connection with an ERISA-covered retirement plan. ERISA-covered plans must comply with federal securities and bankruptcy prohibitions on employment discrimination and other such laws and prohibitions. Also, governmental plans, such as governmental 457(b) plans and Section 403(b) arrangements are not affected by ERISA, so governmental plans are regulated by state statutes and regulations.
There are three primary ways that annuities can be used for tax-favored retirement plans:
Annuities can be used to fund a tax-qualified plan, a governmental 457(b) plan or Section 403(b) arrangement. Usually the assets of tax-favored retirement plan must be held in trust by one or more trustees, or in a custodial account with one or more custodians.182 But an annuity issued by an insurer that is qualified to do business in the state may be used instead of a trust or custodial account.183These plans are often called “non-trusteed plans.”
Annuities may be held as an investment asset in a trusteed retirement plan. As an example, the plan could purchase and then hold in trust a group annuity contract that would provide a method for offering and making life contingent annuity payments to participants; therefore, the trustee would be the owner of the annuity contract.
An annuity may be provided to the participant of a retirement plan with the participant as the named owner. This way, the insurer assumes the obligations of the plan.
As a general rule tax laws do not require or restrict the design of annuities that are used in tax-favored retirement plans, and, as a matter of fact, individual and group annuities, participating and nonparticipating annuities, fixed and variable, deferred and immediate annuities are all permitted. The plan should be appropriate for the plan, for the type of business being funded, how it is to be paid, etc. Sometimes a retirement plan may have some conflict with an existing plan, sometimes an annuity just does not provide what is needed as the individual need had not been contemplated. In these cases, an endorsement and/or rider can accomplish what is needed.
Annuities are used in defined contribution plans and defined benefit plans, both. Section 403(b) arrangements and governmental 457(b) plans are nearly always defined contribution plans, but qualified plans can be either defined contributions plan—such as a 401(k)—or defined benefit plan. Since rules differ between defined contribution plans and defined benefit plans, the differences can have an impact on the annuity used in the plan.
Defined contribution plans provide benefits that are based entirely on an account balance maintained for the benefit of an employee.184 The employees account consisted of contributions and investment earnings or losses, and many defined benefit plans allow the employee to pick the investment of the amounts that are credited to their account. Many of these defined contribution plans are invested in variable annuities that offer variable investment options and/or a fixed account option.
A defined benefit plan is any plan other than a defined contribution plan.185 Normally a defined benefit plan expresses benefits as a periodic pension to be paid for the life of the employee after he retires. There are other plans, including cash balance plans, that define the employee’s accrued benefits in a different manner.
Interestingly, the tax code does not define “annuity” but it does require several requirements on annuity contracts. Generally, the tax law requirements for annuity contracts do not apply when annuities are used with a tax-favored retirement plan, in which case there are some specific requirements.
One requirement is that annuity contracts that are used in qualified tax-retirement plans are exempt from the diversification requirements that apply to variable annuities.186
Another requirements is that annuities used in tax-favored retirement plans are exempt from the IRS Code that states that the annual increase in an annuity held by a nonnatural person is taxable to the owners, unless the contract is held as an agent for an actual person, with the effect that a nonnatural person that owns an annuity is taxed on earnings from annuities under qualified plans unless there is an exception—and there is an exception for annuity contracts under qualified plans held by an employer and Section 403(b) arrangements.187
An annuity contract under a qualified plan, Section 403(b) arrangements and IRAs are exempt from after-death distribution rules (Code Section 72(s) and similar minimum distribution rules apply under Code Section 401(a)(9); such rules also requiring minimum distributions during the lifetime of the participant, either after retirement or attaining age 70 ½.
There are nonqualified deferred compensation plans that use annuities , and they are nearly always unfunded arrangements, which allow the deferral of taxation until the benefits are paid or made available to the employee. Employees are taxed on the value of vested deferred compensation to the extent assets of the employer are exempt from the claims of employer’s general creditors, unless the arrangement is informal in which case they are subject to employer’s creditors. An informal funding with annuities does not make much sense as the employer would be currently taxed on earnings of the contract to the extent that the employer is the owner of the contract. However, there is an exception from Section 72(u) for immediate annuities owned by nonnatural person and immediate annuities sometimes are used to pay benefits under such nonqualified deferred compensation plans.188
Tax-favored retirement plans must be “funded arrangements” which is defined as amounts in an annuity funding a tax-favored plan are (usually) kept and held only for the exclusive benefit of the participants.189 The methods used to keep these funds separate and used as intended include trusts, custodial accounts and annuities.
Variable annuity contracts are often used to fund defined contribution retirement plans and the participants have investment control over the allocation of their account balances among separate account and a fixed account investments. The fixed amount is held by the insurer in its general account where it earns interest and the principal is guaranteed and the insurer guarantees a minimum guaranteed investment rate. Amounts that are allocated to the variable investment options under the annuity are held in accounts that are segregated from the insurer’s general asset accounts (in accordance with state laws and regulations). These separate accounts are often mutual funds of other similar investment funds, as discussed earlier.
Variable annuities can also be used to fund defined benefit plans, but unlike the defined contribution plans, separate accounts are not maintained for each participant in the plan and benefits are not defined by the value of the contract. The plan fiduciary responsible for the investing of such funds, usually invests the account value and the employer contributions with the goal of maintaining sufficient funds to satisfy the obligations of the plan which are separate from the contract. If this fund is insufficient to meet the promised benefits, the shortfall is the responsibility of the employer.
It should be noted that in some situations, a fixed annuity that credits interest at a declared rate declared by the insurer and at specified periods of time, may be used in conjunction with a variable annuity contract, thereby, in some situations, allowing the plan to have the flexibility to take advantage of investment opportunities, but at the same time maintain a guaranteed amount (fixed annuity) for the benefit of their employees.
Tax-favored retirement plans may use individual annuity contracts and group contracts.190 As a practical matter, however, group annuity contracts are most often used to fund tax-qualified plans and governmental 457(b) plans, principally because group annuity contracts are less costly than individual contracts, and when applicable, more likely to meet ERISA requirements. Section 403(b) is different as it can be funded exclusively by individual annuity contracts, but group annuity contracts can be used (mainly for ERISA arrangements).
The restrictions on investor control, as a general rule, apply to all annuities. However, the IRS has softened their requirements in respect to restrictions on investments in publicly available funds to retirement plan products and now they allow a variable contract owner to direct investments in publicly available securities if the investments are the same as could be made in a trusteed version of the same plan.
These regulations also apply to qualified plans and Section 403(b) annuities.
The only “special requirements” for an annuity funding a tax-qualified plan is that it must be nontransferable.191 The regulations consider an annuity as being transferable if the owner can sell, assign, discount or pledge as collateral for a loan, as security for the performance of an obligation or for any other purpose, his interest in the contract to any person other than the issuer192. Further, the annuity contract must specifically contain provisions making the contract nontransferable. There is an exception, if the annuity is held in trust as part of a trusteed plan, in which case the trustee is the owner of the contract and transfers by participants are therefore not allowed because of the structure of the contract.193
Other than the nontransferability of the contract, there are no other special requirements required for an annuity that funds a tax-qualified plan. There are numerous regulations and requirements for the plan itself but since the annuity funding the plan usually does not have the qualifications for the applicable plan, the same thing is accomplished by separate plan documentation kept by the employer.
There are certain rules for an annuity purchased by an employer for an employee and that satisfy certain requirements—qualified annuity plans.194 These requirements are the same as those that apply in a Section 401(a) qualified plan that is invested entirely in annuities.
However, there are special funding rules for defined benefits plans invested exclusively in insurance contracts. Tax-qualified defined benefit plans are subject to certain funding rules that require that the plan be funded on an actuarially sound basis.195 Some specific defined benefit plans funded by individual insurance contracts (including annuity contracts) are exempt from minimum funding rules, if they satisfy certain requirements—called 412(i) plans.196
Practically, it has been pointed out, a qualified defined benefit plan that is funded only through annuity contracts and defines its benefits obligations by referring to the terms of the annuity provides much simpler administration because nearly all of the asset management and actuarial computations then become the responsibility of the insurer.
Originally403(b) plans were funded exclusively with annuities, and today they may also be funded through mutual fund custodial accounts. Because of the historical relationship, 403(b) regulations allocate administrative responsibility to the insurer (or custodian when applicable) and that means that some important provisions are usually included in a Section 403(b) annuity.
The IRS now requires that the contract contain the nontransferability requirement197; direct rollover requirements198; and the application annual dollar amount limit on pre-tax salary reduction contributions199 — such dollar amount depending upon the tax year and in some case, the annuitant’s age.
However, primarily because of the historical relationship with Section 403(b) and annuity contracts, there are provisions for 403(b) arrangements, such as certain contribution limits 200, required minimum distribution provisions201; and transfer provisions.202
For an annuity be held as an investment in a tax-favored retirement plan, the trustee of the plan is named as the owner of the annuity with the participant as the covered life owner. In a defined benefit plan that pays annuity benefits, the annuity makes payment to the trust and the trust in turn sends these payments to the annuitant, in effect, paying the plan’s liability. If the insurer became insolvent, the plan would still be obligated to make annuity payments.
In a defined contribution plan a deferred annuity may be one investment along with several mutual funds in which the participant can invest; in effect, the participant allocates a portion of his account to purchasing a deferred annuity.
Qualified (and governmental 457(b)) plans are subject to tax on unrelated business income.203The plan’s investment income from an annuity by itself, does not produce such income unless the plan in some fashion borrows money to acquire the annuity, and the debt-financed income rules would apply.204In actual practice, annuities are generally excluded from the definition of unrelated business income for tax purposes.
Since the assets underlying an annuity are those of the insurance company and is not subject to the unrelated business income tax, therefore the investment of such assets normally doesn’t require analyzing for unrelated business income. There can be situations where the IRS will issue regulations that could impose debt-financed income rules because of or to prevent abuse under segregated asset accounts.
There are few restrictions on the form used to distribute benefits from tax-favored plans, and benefits may be paid in cash or property—such as stock of the employer or mutual fund shares.
The most typical form of non-cash payment or payment by company stock, is a payout (using an annuity contract) by the distribution of an annuity from a trusteed plan that is issued in the name of the participant, or as a transfer of title to an individual annuity in a non-trusteed plan.
As a general rule, annuity benefits have been distributed from tax-qualified benefit plans when the plan is terminated and the annuities are used as a method of terminal funding. This way the distribution of the annuity transfers the liability of the plan to the insurer, who then becomes responsible for making payments.
Sometimes annuities are used in defined contribution plans as an optional method of distribution. A 401(k) plan could, as an example, offer payments in a single sum, in installment payments, or in the form of a distributed annuity.
Individual annuities are usually issued to participants in the plan when the annuity contracts are distributed from a tax-favored plan. Group annuity contracts, however, are often used for plan terminations.205 When they are used for plan terminations, the group annuity is used in the name of the employer (or in trust for the benefit of the participants) and individual certificates are issued to the participants.
Typically, the taxation of an annuity that was paid out of a tax-qualified retirement plan is first determined if the plan is transferable. If it is transferable, then the fair market value of the contract is taxable to the person receiving the distribution.206
If the plan is nontransferable, and assuming the plan meets the qualification requirements applicable, the contract is tax deferred and tax is assessed only upon actual payments from the contract.207 The right of an individual to surrender a nontransferable contract for value, does not affect the taxation. The cash surrender value is considered as income only when the contract is actually surrendered.208
The principal requirement that a distributed annuity must satisfy is primarily if the contract is taxable at the time it is distributed. If it is taxable, there are no particular requirements that apply to the contract, but if the distribution is not taxable on the value of the annuity because it is, in fact, nontransferable, then the annuity is required to adhere to several tax-qualification requirements.
The IRS or the Treasury Department have provided no specific requirements for an annuity distributed from a tax-qualified plan to adhere to and there are several unanswered questions regarding the status of a distributed annuity contract. As an example, it is unclear if loans are permitted from a distributed annuity contract , or whether a distributed annuity can accept rollover contributions. The answers seem to hinge on whether on whether a distributed annuity is considered as a continuation of the qualified plan. If it so considered, then probably the contract would have to satisfy all of the requirements of qualification and would then be entitled to the benefits of qualified plan status such as those regarding loans.209
It has been suggested that the distributed annuity contracts must satisfy some (limited) qualification requirements but are not subject to all of the qualification requirements.
Most tax-qualified plans require that the distributed annuity contract must show the direct rollover requirements of Section 401(a)(31) and the spousal consent requirements of Section 401(a)(11) which requires the insurer to be responsible for obtaining spousal consent to certain distributions. Also the distributed annuity must satisfy certain anti-cutback rules which specifies that benefits, which include some optional forms of payout, must be preserved in the distributed annuity to the same extent that they need to be preserved in a plan210 and minimum distribution rules of Section 401(a)(9).
Using an annuity contract to provide distribution to participants in tax-favored retirement plans can be accomplished by making distributions from annuity contracts that have been distributed to plan participants, directly from an annuity that funds a plan and to a trust that is the legal owner of the annuity with the trustee then making payments to participants.
There are certain minimum distribution rules that limit the beneficiaries to indefinitely defer taxation under tax-favored plans.211 The Code specifies detailed minimum distribution requirements on qualified plans, Section 403(b) arrangements, and governmental 457(b) plans.212These rules require that a participant’s benefit be distributed within a certain period of time after the later of the date that the participants reaches age 70 ½, or retires from employment with the employer who is maintaining the plan. Also, there are certain rules that outline when payments must start if a participant dies before the payment of benefits has started.
Basically, there are two methods for determining the minimum amount that must be distributed during the lifetime of the participant’s lifetime, regardless if the payments are made under a defined contribution plan or a defined benefit plan.213
With a defined contribution plan, the minimum amount that must be distributed each year is the participant’s account balance divided by his life expectancy (or the joint life expectancy of the participant and the beneficiary).
In a defined benefit plan, the distributions must be paid in the form of periodic annuity payments for the employee’s life expectancy, or the joint life expectancy of the participant and the beneficiary or over a period certain that does not exceed specified durations.
Treasury Regulations state that how benefits are paid under an annuity that satisfies Section 401(a)(9) will depend upon how the annuity has been annuitized. Prior to the date that an annuity contract under a defined contribution plan is annuitized, the annuity is considered as a defined contribution plan for purposes of these regulations. After the annuity is annuitized, the annuity must satisfy the rules that apply to the benefits paid from defined benefit plans.
Interestingly, neither the Tax Code or Treasury Regulations define “annuitized” either for purposes of these regulations under discussion here, or for any other purposes. Therefore, usually “annuitized” is defined roughly as an amount “received as an annuity.” This approach is probably the most correct definition as, for instance, Section 72 distinguishes between amounts that are “received as an annuity” and amounts that are “not received as an annuity.” Payments that are made under an annuity contract usually are considered as amounts received as an annuity only if they are received on or after the “annuity starting date” (the date upon which benefits become fixed or the first day of the period that ends on the date of the first annuity payment); the amounts must be paid periodically at regular intervals over a period of more than one (full) year from the starting date; and the total amounts payable must be known at the starting date of the annuity, either so stated in the contract, or by use of mortality & compound interest tables, or both, based upon sound actuarial theory.214
If an annuity has been held in a defined contribution plan (not yet been annuitized) the minimum amount that is required to be distributed each year is the interest that the participant has in the contract, divided by the life expectancy of the participant, or joint expectancy of the participant and the beneficiary. This looks familiar because it is the same requirements as that of a defined contribution plan, except for some minor changes, such as the participant’s interest includes the actuarial present value of any additional benefits (without taking into consideration the health of the individual), such as survivor benefits that are more than the amount credited to the employee or beneficiary. Other changes that could occur are used infrequently and usually are disregarded.215
When an annuity has been annuitized, the form of the payment must meet certain requirements, but distributions will satisfy these requirements if they are made in periodic annuity payments for the lifetime of the employee, or joint life of employee and beneficiary, or over a period certain. The life annuity may provide for a period certain, but it must not exceed the life expectancy of the employee unless if the annuity provides only a period certain and no life annuity and the sole beneficiary is the spouse, then the period certain can be the longer of (1) the employee’s life expectancy, or (2) the joint life and survivor expectancy of the employee and the spouse.
Annuity payments must be made at uniform intervals, for a period of not more than one year and the payments must increase only in accordance with a cost-of-living index, under some survivor benefit arrangements, to provide cash refunds of employees contributions upon his death, to pay for increased benefits under the plan, or for complex rules permitting certain types of death benefits when the account balance is being annuitized.216
If only part of the account balance is annuitized, then the remaining amount in the account must be distributed according to the defined contribution plan rules. This also applies to defined benefit plans.
Roth IRAs are exempt from lifetime required minimum distributions and are subject only to after-death minimum distribution rules.217
A qualifying distribution that is attributed to a Roth qualified plan or Section 403(b) arrangement is exempt from the lifetime minimum distribution rules. This creates an incentive for participants to rollover amounts attributed to Roth Plan contributions to Roth IRAs.
There are certain spousal consent requirements for tax-qualified retirement plans and ERISA-Section 403(b) arrangements, but not to non-ERISA-Section 403(b) plans or governmental plans. These requirements give the spouse of a participant an interest in the participant’s accrued benefits and there must be spousal consent for certain distributions and non-spousal beneficiary designations. For defined benefit plans principally, the benefits must be paid in the form of joint and survivor annuity unless the spouse consents to another method of distribution. For defined contribution plans but not money purchase plans, the spousal consent does not apply if the plan provides that the account balance is payable at death, to the spouse of the participant, unless the spouse agrees to another beneficiary.218
Spousal consent requirements do apply if a participant elects payment in a life annuity. Spousal consent is required for payment in any form other than a qualified joint and last survivor annuity if any election of a life annuity is made.
For tax purposes, a qualified joint and survivor annuity is an annuity for life of the participant with a survivor annuity for the life of the spouse which is not less than 50% or greater than 100% of the annuity amount payable during the joint lives of the participant and the spouse.
Whether a variable annuity that satisfies the joint and survivor annuity rules may be considered as a qualified joint and survivor plan is unclear and at this point the IRS has made no ruling—one way or the other. They may not consider a variable annuity as a qualified joint and survivor annuity because the spouse could receive an amount less than the 50%, depending upon the investment performance.
Distributions are taxed as ordinary income except to the extent the distributions represent the individual’s investment in the contract (which is the amounts that have already been taxed). This does not apply to a Roth arrangement because they are entirely excludible from gross income, even if the payments are not received from an annuity.219
The taxation of a distribution not received as an annuity depends entirely upon whether the distribution was received on or after the annuity starting date, or before the starting date of the annuity.
F If the distribution was made on or after the annuity starting date, the entire distribution is includible in gross income. If the distribution was received before the starting date, the distribution is includible in gross income only to the extent that the distribution is not allocable to the individual’s investment in the contract.
Subject to a couple of exceptions, the IRS has graciously supplied a simplified method of determining the nontaxable part of the amounts that are received as annuities from qualified plans and Section 403(b) annuities. To use this method, the non-taxable part of each annuity payment is calculated by dividing the investment in the annuity by the number of “anticipated payments” which is determined by the following tables based on the age of the primary annuitant on the annuity starting date or the combined ages for joint and survivor annuity.
SINGLE LIFE ANNUITY TABLE
Primary Annuitant’s Age Number of Payments
Age 55 or less 360
More than 55 but not more than 60 310
More than 60 but not more than 65 260
More than 65 but not more than 70 210
More than 70 160
JOINT AND SURVIVOR ANNUITY TABLE
Combined Age Number of Payments
Not more than 110 410
More than 110 but not more than 120 360
More than 120 but not morel than 130 310
More than 130 but not more than 140 260
More than 140 210
NOTE: The simplified basis rules do not apply and the exclusion ration applies if the primary annuitant is 75 year old or older, unless there are less than five years of guaranteed payments under the annuity.
An additional tax of ten percent of the amount that is includible in the gross income, applies to some early distributions from qualified plans and Section 403(b) programs. This tax does NOT apply
The exception from the penalty tax for substantially equal periodic payments as discussed earlier in the text when addressing taxation of variable annuity payments, has been the subject of many Revenue Rulings, Tax Codes, Q&A of notice, Treasury Regulations and Private Letter Rulings. These are rather complex but basically they provide three methods that can be used for calculating substantially equal periodic payments, including payments from deferred variable annuity contracts.220
One of the major problems is that the IRS has not as yet published any guidance on how the substantially equal period payment exception to Code Section 72(t) applies in the case of variable annuity payments. The congressional Staff of Joint Committee on Taxation, et al, did publish in 1982 an observation that seems to appear that variable annuity payments can qualify as substantially equal periodic payments for purposes of Section 72(t).
In any event, this is a rather complex situation and expert tax advice is needed in regards to possible problems of early distribution tax with variable annuities, but the question as to whether variable annuity payments are treated differently than with fixed annuities appears at this point in time, to be a moot point, but until the IRS is more specific, should be carefully checked if the question arises.
As a general rule, the IRS allows transfers of amount with a plan to be tax free under the theory that such transfers are really investment allocations and it is only distribution under tax free plans that are taxable but transfers within a plan are not taxable.221
It is apparent when a distribution from a trust has been made, but plans that are funded through individual annuity contracts can give rise to questions as to if there was a distribution. A lot of the determination will depend upon the wording in the employer’s plan document. If there is an individual annuity funding a plan and it is exchanged for another annuity, whether the transferee contract is still part of the plan will depend upon whether such a contract was expected under the plan document.
Section 403(b) arrangements often do not have formal plan document, but the IRS generally allows transfers of annuity contracts without employer involvement as long as they are subject to any early distribution restriction that would be imposed on the funds prior to transfer. Transfers are allowed even if the participant is no longer a current employer, former employee, or a beneficiary.
As another general rule, the IRS will allow tax free exchanges as long as the second plan is the same type as the first as they are not considered as distributions. Direct transfers are permitted between Section 403(b) arrangement (if the funds are subject to the same or tougher restrictions regarding in-service distributions); between qualified plans and between governmental 457 plans.
As a note of interest, transfers between the tax-favored plans often can be accomplished by the employer without the consent of the employee agreeing or even being involved, including transferring the entire plan to another employer’s plan, such as part of a business transaction or to another insurer, with no tax implications. A group annuity contract held in trust can be transferred by the trustee to another contract without tax consequences.
If the annuity funding the retirement plan is an individual annuity owned by a participant, the participant cannot assign or alienate their interests in an individual annuity contract, but usually the IRS will allow a transfer within and between plans. Section 403(b) arrangements have allowed taxpayer to transfer all or part of his Section 403(b) contract to another Section 403(b) contract, whether there is any employer involvement or not.
The IRS has at times maintained that the nontransferability restrictions extends to and prohibits transfers initiated by individual annuity owners, considered as transfers outside of the plan. However, they have on occasion taken the position that participant-initiated direct transfers of annuity contracts are permitted in regards to annuities distributed from a qualified plan in connection with the plan termination, in effect maintaining that the nontransferability requirements does not restrict direct transfers.
While the IRS usually allows tax-free direct transfers of annuities, this would be only if the same type of plan is involved.
The rule governing transfers of assets and benefits from one tax-qualified plan to another is that
F a merger, transfer, or spin-off of plan assets and liabilities must ensure that each participant receives a benefit immediately after the merger or transfer, that is equal to or greater than the benefit he would have been entitled to receive immediately before the merger or transfer.222
Simply put, there is nothing in Code Section 1035 that limits it to nonqualified annuities, and courts have applied it to exchanges in respect to Code Section 403(b) annuities only so the IRS limits tax free exchanges only with Section 403(b) arrangements.
However, in respect to qualified plans, the IRS takes the opposite view. The IRS base their opinions on the difference because any such exchange must be permissible under the Code provisions that govern that particular type or qualified plan or arrangement, so therefore, the qualification conditions make Section 1035 inapplicable.
A rollover is a distribution paid into another tax-favored plan under certain IRS rules. Basically, an employee (or spouse) who is a distributee may choose to have an eligible rollover distribution paid directly to an IRA, other qualified plan, or Section 403(b) annuity. This is considered as a direct rollover.223
If the rollover is not a direct rollover, then the rollover is a traditional rollover which must be made within 60 days (subject to hardship exceptions) of the distributee’s receiving the distribution. If the plan is a qualified plan, Section 403(b) annuity or governmental 457(b) distributions must meet other requirements.224
By rolling over a distribution the distributee avoids an early distribution tax and can defer income taxes until the amounts are actually received. Part of all of a qualified plan, Section 403(b) annuity, or governmental 457 plan can be rolled over to an IRS or to a qualified plan, Section 403(b) annuity or governmental 457(b) plan (if the governmental plan accepts rollovers).
As a general rule, an “eligible rollover distribution” is any distribution to an employee or spousal distribute, of all or any portion of the balance to the credit of the employee in a qualified plan, Section 403(b) annuity or governmental 457(b) plan.
There are some types of distributions from a qualified plan, 403(b) or 457(b) plan that may NOT be eligible rollover distributions:
In some cases, distributions of the surviving spouse of an employee, or to a spouse or former spouse of an employee may be eligible rollover distributions.
If an employee elects to perform a direct rollover of a distribution to an IRS or other qualified plan, Section 403(b) annuity or governmental 457 plan, the amount rolled over is not subject to federal income tax or any federal tax withholding.226
F However, If an individual that is entitled to an eligible rollover distribution does not elect to directly roll over the distribution, then the payer of the distribution must withhold 20 percent of the portion of the distribution that is not rolled over, as income taxes.
There is an exception to this in cases of hardship after distribution. But, for the individual to avoid income tax on the portion of the distribution that was withheld, he must contribute money from his own funds.
If the person does not make a rollover to an IRA, another qualified plan, 403(b) or 457(b) plan within 60 days after receiving a distribution, he will be subject to income tax on those amounts, and in addition, may be subject to the 10 percent early distribution tax.
If distributions are made that are not eligible for rollover distributions from a qualified plan, 403(b) or 457(b) plan, the 20 percent is not assessed. Periodic distributions are then treated as wages and are subject to withholding as such unless the individual elects to not have any withholding. If the person makes no election (does not file Form W-4P), then the tax will be withheld as if the person were married with three withholding allowances. Lump-sum distributions are subject to a flat withholding rate of 10 percent unless the person elects no withholding.
Rollover distributions from an annuity contract that is part of a tax-qualified plan are basically treated as distributions from the plan. In effect, the insurer functionally replaces the plan so that payments are eligible for tax-free rollover if they would otherwise be eligible, and the insurer provides the proper notice to the IRS (402(f)) which verified that the employee now has a direct rollover option and withholding per the tax-qualified plan.
While loans from nonqualified annuity contracts are treated as taxable distributions, the loans from an annuity issued as part of a tax-favored retirement plan can be made on a tax-taxable basis—that is, if the loans are permitted under the plan and the loans satisfy IRS requirements.227
As a general rule, loans are permissible if it does not exceed the lesser of $50,000 less outstanding loans or the greater of half the present value of the participant’s nonforfeiture accrued benefit or $10,000.228 The loan must be repaid within five years and must be amortized in substantially level payments. Also, there is an exception to the 5-year requirement for loans that are used to purchase a principal residence.229
If the IRS requirements are not met when the loan is made or later—such as in default because of failure to make timely payments—the loan is considered as a distribution for income tax and reporting purposes. When the participant’s benefit is offset to repay the loan, then the loan amount is called a loan offset amount.
An interesting ruling under ERISA for ERISA-covered plans state that since certain state and federal laws prohibit employers from discrimination, then since the employee benefit programs cannot provide benefits or distributions that discriminate by sex, the safest approach is to use annuities with unisex rates where arrangements may be subject to such laws. This does not apply to IRAs, therefore,
F men usually are better off rolling over their retirement benefits to an IRA to purchase an annuity. Conversely, women are generally better off to purchase an annuity through a workplace retirement plan.
A Traditional IRA can be a trust or custodial account under Code Section 408(a) or an annuity contract under Code Section 408(b). The traditional IRA annuity contract is an annuity contract or endowment contract issued by an insurer and meets certain criteria:
For federal income tax purposes, contributions to traditional IRAs can be made several ways, and the federal income tax income treatment of any specific contribution will depend upon the form of the contribution. Earnings on contributions are not included in gross income until they are distributed from the IRA.
Contributions to a traditional IRA can be in the form of regular IRA contributions, rollovers and transfers from other traditional IRAs owned by the individual, rollovers from SEP IRAs, rollovers from SIMPLE IRAs and eligible rollover distributions from tax-qualified pension plans, Section 403(a), tax-sheltered (403(b)) annuities, certain trusts and custodial accounts, and plans maintained by a government employer.
A Roth IRA must be so designated at the time it is established, and generally no deduction is allowed for contributions, investment earnings held in the Roth IRA are not taxable while they remain in the Roth IRA and distributions are not includible in gross income and are not subject to the 10 percent withdrawal tax, provided that they constitute qualified distributions.
For federal income tax purposes, a Roth IRA is treated the same as a traditional IRA except that differences exist between the two relating generally to differences in the treatment of contributions and distributions.
A Roth, like a traditional IRA, can be a trust, custodial account or annuity contract. A SIMPLE IRA cannot qualify as a Roth IRA.
Neither traditional or Roth IRAs can be invested in life insurance. Also, an annuity contract that includes a substantial element of life insurance does not qualify as an IRA annuity.
Contributions to a Roth IRA can be regular Roth IRA contributions, rollovers and transfers from other Roth IRAs of the individual, and conversions of amounts held in non-Roth IRAs of the individual. Subject to certain income requirements, a person who has not made the maximum annual contribution to a non-Roth IRA can make a regular contribution to a Roth IRA.
A parent or guardian may establish a Roth IRA on behalf of a minor child, or others who lack legal capacity to act on his behalf, provided certain compensation requirements have been satisfied.
Federal income tax laws do not require that a taxpayer maintain separate IRAs for each type of contribution. Some maintain separate Roth IRAs for regular contributions, rollover and transfer contributions, and conversion contributions. However, the administrative cost of maintaining separate Roth IRAs could be greater than such costs for maintaining one Roth IRA only.
The total maximum regular contribution that an individual is allowed to make yearly to traditional and Roth IRAs that are set up for his individual benefit, is the lesser of the maximum annual contribution allowed under the Tax Code (219)b)), or the individual’s annual compensation.232
The maximum contribution allowed each year for 2005 through 2007, is $4,000 (goes to $5,000 in 2008). A person who is age 50 or older can make “catch-up” contributions by increasing their contribution by $5000 for 2002 through 2005, $1,000 for 2006 and after.233
Employer contributions to a SEP IRA or SIMPLE IRA do not count toward the maximum annual contribution limit and higher contribution limits apply to these type of IRAs.
Tax-free transfers of amounts between IRAs and rollover contributions are not considered as regular contributions and have no effect in determining maximum contribution amounts. Tax-free transfers of amounts between Roth IRAs and qualified rollover contributions from one Roth IRA to another Roth IRA are not considered regular Roth IRA contributions in determining maximum contribution amounts.
Note: There are numerous other regulations and requirements for IRA arrangements, however these regulations are easily obtained if the need should arise and are beyond the purview of this text as practically, annuities are a small portion of IRA investments.
STUDY QUESTIONS
1. On qualified annuity plans,
A. the use of benefits must be restricted to retirement purposes.
B. benefits may be used for health purposes, educational and for homeownership.
C. the benefits may be used for any purpose as designated by the plan owner (employer).
D. there are no limitations as to contributions or benefits on behalf of any employee.
2. Under a qualified plan, contributions and earnings become taxable
A. from inception.
B. at any point.
C. only when they are distributed.
D. only when they are accumulated.
3. Defined contribution plans provide benefits
A. that are based partially on an account balance maintained for the employer and employee.
B. that are based entirely on an account balance maintained for the benefit of an employee.
C. are expressed as a periodic pension to be paid for the life of the employee after
retirement.
D. that are never taxable during the contribution period, and then are taxable as capital gains.
4. In determining whether an account is a qualified plan, the IRS requires that the plan must be a “funded arrangement”
A. which means that the funds are held for the benefit of the employer only.
B. which automatically makes them available to creditors.
C. that can be funded by the employer for their own use.
D. which are (usually) kept and held only for the exclusive benefit of the participants.
5. In determining the taxation of the distribution of an annuity from a tax-qualified retirement plan, the first thing is to determine
A. if the plan is transferable or nontransferable.
B. if loans are permitted.
C. how long has the plan been in operation.
D. if the plan has met all of the many and various qualification requirements.
6. Roth IRAs
A. are not exempt from lifetime required minimum distributions.
B. are taxed as ordinary income after the plan has been in effect for 3 years.
C. are exempt from lifetime require minimum distributions and are subject only to
after-death minimum distribution rules.
D. are not subject to after-death minimum distribution rules, ever.
7. If a distribution is made from a tax-qualified plan on or after the annuity starting date,
A. the entire distribution is includible in gross income.
B. none of the distribution is included in gross income.
C. only the part of the distribution that is allocable to the individual’s investment in the
contract is included in gross income.
D. only the part of the distribution that is allocable to the employer’s investment in the
contract is included in gross income.
8. If an individual that is entitled to an eligible rollover distribution from a qualified plan does not elect to rollover the distribution,
A. he has 45 days to either rollover to another plan, or spend the money for health reasons,
new automobile or home ownership, or to pay off student loans, without penalty.
B. the payer of the distribution must withhold twenty percent of the portion of the distri- bution that is not rolled over, as income taxes.
C. there is a ten percent penalty that the individual must pay when they next file their
personal income tax return.
D. he must file a petition with the probate court in order to get access to the distribution.
9. Loans from nonqualified annuity contracts are treated as taxable distributions, and the loans from an annuity issued as part of a tax-favored retirement plan
A. are also treated as taxable distributions.
B. are not allowed.
C. can be made if the loans are permitted under the plan and the loans satisfy IRS
requirements.
D. are treated as surrenders and considered as gross income for tax purposes.
10. Because of a ruling for ERISA-covered plans that require employee benefit programs to not discriminate by sex, the safest method is to use annuities with unisex rates (when available by law). This does not apply to IRAs, therefore
A. men are usually better off rollover retirement benefits to an IRA to purchase an annuity,
women are better off to purchase an annuity through a workplace retirement plan.
B. women are usually better off rollover retirement benefits to an IRA to purchase an
annuity, men are better off to purchase an annuity through a workplace retirement plan.
C. for ERISA-covered plans, annuities should not be used.
D. no one should purchase an annuity where unisex rates are used.
CHAPTER EIGHT:
1A 2C 3B 4D 5A 6C 7A 8B 9C 10A