The taxation of annuities has remained functionally the same in recent years, with taxation changes being more applicable to “methods” instead of “instruments.” For example, the rather recent regulations regarding Individual Retirement Accounts (IRA) and the addition of the Roth IRA affects the taxation of the method of accumulating funds, and not whether the underlying mechanism to fund the IRA is taxed differently than previously. However, a note of caution: while annuity products have retained tax advantages through numerous revisions in tax laws and Internal Revenue Service and tax court rulings, both laws and interpretations are subject to change. When the precise details of taxation are important to decisions regarding annuities, professional counsel is imperative. The information in this textbook does not represent legal or professional advice of any kind.
The premiums an individual pays for a nonqualified annuity are not tax deductible for federal income taxation purposes. For a qualified annuity, an Individual Retirement Annuity (IRA), the premiums are deductible according to the rules as described elsewhere. When the IRA owner is also covered by an employer-sponsored retirement plan, the amount of the tax deduction permitted gradually decreases until it reaches zero (when the stipulated adjusted gross income maximums are reached).
Annuities may be used to fund group retirement plans. When these are qualified retirement plans, the premiums, or contribution as they are often called, are tax deductible to the employer who makes the deductions on behalf of employees. A Keogh plan can appear to provide an individual tax deduction when the plan benefits only a sole-proprietor who has no employees. In this case, the effect is the same as an individual’s deduction.
Payments made to qualified annuities are either tax deductible or the amounts used for this purpose are not declared as current income when paying income taxes. For example, an employer’s contributions to a group annuity are not reported as income when the contribution is made. And, while the employer’s contribution to an employer-sponsored IRA must be reported as income, it is “washed out” by the tax deduction the employee takes.
Some states assess state premium taxes on annuity premiums. When this is the case, the purchaser does not pay a separate tax. Instead, the insurance company deducts the correct amount from each premium payment and pays the tax directly to the state. Where state premium taxes apply, they generally equal about 2% or 2.5% of the premium. Some insurers pay the premium taxes themselves and do not deduct the taxes from the annuity premiums.
FDuring the accumulation period, qualified or non-qualified annuity values build on a tax-deferred basis, with the interest remaining untaxed until money is withdrawn from the annuity.
As stated earlier, interest paid on deferred annuities is not taxed until annuity funds are withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement, the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined as withdrawals before the individual’s age 59½. These tax consequences include current income taxation and an additional penalty tax.
In general a distribution occurs when the employment is terminated, the employee retires, or the plan is terminated. However, there is a premature distribution tax of 10%, which is applicable to many distributions from qualified retirement plans. This premature distribution tax is in addition to any income tax due on the distributions.
As with most laws or regulations, there are exceptions. They have been divided into three categories by many accountants and other tax practitioners.
Generally, the first exception(s) treats the reason as to why the distribution was made. Obvious exceptions are death or disability before age 59 ½. The least obvious exceptions are
The second exception(s) allows distributions because of separation of service for any reason, as long as they are in the form of a “Qualifying Annuity.” Basically, a qualifying annuity is an annuity starting at any age and paid in (substantially) equal payments and not less frequently than annually, for the life of the participant and his/her beneficiary. The qualified plan may purchase commercial annuities to satisfy the requirements of this exception. (Does this bring visions of “golden parachutes” funded by annuities?)
The third is the “roll over” discussed briefly earlier. The key words for this exception are “timely” and “fully.” This exception can be lost if it takes more than 60 days for a participant to make up their mind, and if less than the entire plan distribution is rolled into the new IRA or other qualified retirement plan.
The IRS addresses “roll-overs” as “a distribution that is paid into another tax-favored plan in accordance with the applicable rules; it may be a direct rollover or a traditional rollover.”29
An employee of spousal distributee may elect to have an eligible rollover distribution paid directly to an IRA or another qualified plan, or Section 403(b) annuity, for governmental 457 plan in a direct rollover. A qualified plan, Section 40-3(b) annuity, or governmental 457 plan is required to allow a distributee of all eligible rollover distribution to make a direct rollover to an IRA or any defined contribution plan, Section 403(b) annuity, or governmental 457 that accepts rollovers.29 The qualified plan, Section 403(b) annuity or governmental 457 plan may, however, require that an employees aggregate eligible rollover distributions for a year exceed $200 (and may impose a minimum of $500 for partial rollovers) before the employee may elect a direct rollover.30
If the rollover is not made under the direct rollover rules, the rollover is a traditional rollover. Such a rollover generally must be made within 60 days (subject to possible exception for hardship) of the distributee’s receipt of the distribution, and in the case of a qualified plan, Section 403(b) annuity or governmental 457 plan distribution, must meet the other requirements for eligible rollover distributions.31
There is no specific tax penalty for those who retire after age 59 ½, but there is a reduced benefit in Social Security payments for retiring prior to age 65.
Funds that are paid to a participant at normal retirement age escape taxation only on the funds that they have contributed to the plan. The funds that the employee contributes have been taxed earlier, so are not subject to tax again at retirement.
Distributions can be made either in installments or annuitized.
FDistributions that are made in installments are taxed as ordinary income in the year they are received.
For annuitization, there are separate rules. First, as can be expected, if the person receiving the distribution (the distributee) has not paid any money into the plan (i.e. has no cost basis), then all payments are taxed as ordinary income.
Secondly, if there is a cost basis (i.e. the distributee has paid for part of the retirement plan) and if any distributions are made before the annuity starts, then part of the distribution will be taxed as ordinary income, and part as a “return of cost basis.” In order to determine the cost basis portion of the distribution, the following formula can be applied:
Total amount of previously taxed employee contributions .
Total present value of annuitant’s account balance or accrued benefit.
Lastly, the formula may be used only until the distributee has recovered the entire cost basis. If the distributee/annuitant dies and has not recovered the entire cost basis, then the amount that has not been recovered can be used as a deduction on the annuitant’s last income tax return.
If a person chooses to take the distribution in a lump sum, they can do so and qualify for the favorable tax treatment, but the employee must be at least age 59 ½, or dies, separated from service (common-law employees), or become disabled (self-employeds). The distribution must be 100% of the employee’s account balance/accrued benefit, and further, the entire distribution must be made in one taxable year!
When a partial withdrawal is taken from an annuity contact before the annuity starting date, the amount that is received is usually includible in income to the extent of any income on the contract. “Income on the contract” is defined by the IRS as the excess of the cash value of the contract, ignoring any surrender charge, immediately before the amount is received over the investment in the contract at that time.
When income on the contract is determine in respect of a partial withdrawal, the entire cash value of the annuity and the entire investment in the contract must be taken into consideration, even if the partial withdrawal was made from a particular subaccount under a Variable Annuity.
If the amount of the partial withdrawal exceeds the income on the contract, the excess amount is considered as a return on the investment in the contract and is not included in income. The net effect of these rules is on a partial withdrawal, the last-in, first-out (LIFO) basis is created.
The IRS has maintained that in certain situations partial withdrawals that are taken in the form of “systematic” withdrawals - such as in the case of a death benefit payment - can be considered as amounts received as an annuity and can be taxed as annuity payments.
The “aggregation rule” is used for the purpose of measuring the amounts includible in gross income32 –when an annuity is surrendered or a partial withdrawal is made, then all annuities issued by the same insurance company to the same policyholder during any calendar year are to be considered as a single contract. It also states that all affiliated insurers will be treated as one company for such purpose. There still are some questions not completely satisfied regarding the application of this rule in connection with annuitization and following a tax-free exchange.
There is another aggregation rule that provides that two or more annuity obligations or elements that are acquired for a single consideration - which could be paid by more than one person and in more than one sum – will be treated as a single annuity. The purpose of this rule (which was issued in 1956) was to combine annuity obligations under qualified plans that by doing so, would simplify their income tax treatment.
Also, the IRS has ruled that 2 deferred annuities issued in a tax-free exchange – replacing one deferred annuity – are treated as a single, aggregated contract, therefore under the rule amounts distributed from one contract to pay required premiums under the other contract are not treated as distributions taxable under the IRS Code.
Mention should be made of the TRA ’86 related to those who reached age 50 by 1/1/86, and who elected to receive lump sum distributions on contributions made prior to 1/1/1974. Without going into all of the technicalities of this rule, this allowed for some of them to be taxed on the capital gains basis. These rules do not apply to distributions from tax sheltered annuities.
For those who attained age 50 after 1/1/86, the rules are more pertinent. They cannot have portions of a lump sum distribution on pre-1974 contributions taxed as capital gains as opposed to ordinary income. They lose the right to any income averaging on lump sum distributions before they reach age 59 ½. In addition, under TRA ‘86 there was a 10 year averaging of a lump sum distribution, that was reduced to 5 years, but effective 1/1/2000 even the 5-year averaging will not be available.
This TRA ’86 is discussed here as it is still applicable in certain situations. For example, for an individual retiring at this time, and who has contributed to their retirement plan, there are several choices that reflect the taxation of distributions. The following are some of the choices that may or may not be applicable:
As should be obvious, this is a highly technical area of taxation but if it should arise, it would call for the professional expertise of a highly qualified tax accountant.
This subject has been approached previously, but deserves more detail and some repetition.
Any income tax on an annuity or insurance contract that has been distributed from a qualified plan can be postponed by converting the annuity or insurance contract to a “nontransferable” annuity immediately (according to recent action by the IRS, although within 60 days is still in the regulations – but why take a chance?). Current taxation on the qualified distribution can be avoided if it is rolled over into a regular IRA.
Once the funds have been deposited into the IRA, taxes will not have to be paid on the rollover until the IRA starts to distribute its assets. Any lump sum distribution will be taxed as ordinary income, and any annuity distributions will be taxed as previously discussed.
A partial distribution to an employee of the funds held in their account may be rolled over into a regular IRA unless (1) the employee reaches age 70 ½, (2) payments will be made for 10 years periodically or for the life expectancy of the employee, or (3) the amounts are not included in the gross income in the absence of the roll over.
For exchanging a nonqualified annuity for another annuity tax free if:
The IRS has held that the direct transfer of an entire annuity contract into another preexisting annuity contract qualifies as a tax-free exchange under Code Section 1035.86
The income tax that must be paid on an early withdrawal or surrender is based upon whether or not the cash accumulation value of the annuity is greater than the premiums paid at the time of withdrawal. When the cash value is greater, the so-called interest-out-first rule applies and the withdrawal is taxed entirely as interest to the extent of the cash value excess.
CONSUMER APPLICATION
Billy has paid $15,000 into his annuity which has a present cash value of $20,000 when he decides to withdraw $3,000. The value of the annuity is $5,000 more than he has personally paid in. Therefore, the $3,000 will be subject to taxation as interest.
Billy decides that if he has to pay taxes on his withdrawal, he will have to take out more money in order to purchase what he wants, so he withdraws $6,000. Then the first $5,000 is treated as interest, and the other $1,000 is treated as both interest and principal, with taxes to be paid only on the interest portion of the $1,000.
To reiterate, interest paid on deferred annuities is not taxed until annuity funds are withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement, the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined as withdrawals before the individual’s age 59½. These tax consequences include current income taxation and an additional penalty tax.
Under IRS Code Section 72(q) there is a 10 percent penalty tax on the taxable portion of distributions from nonqualified annuities.
F The 10% penalty tax is imposed in addition to the income tax otherwise due.
A penalty tax also applies to early withdrawals from the annuity, taken in a lump sum before age 59 1/2. This penalty, requiring an additional tax of 10% of the withdrawal, applies whether or not the annuity is a tax-privileged retirement plan. However, the tax law lists several specific situations under which the 10% penalty is not assessed even if the withdrawal or distribution begins before age 59½:
In addition, if the withdrawal is not taken in a lump sum, and is paid out in installments, each of about the same amount and paid over the annuitant’s lifetime, the penalty tax is not assessed.
While only a few insurers offer loan options with annuities, it must be understood that a loan from an annuity is treated as the receipt of current income. As a result, the amount of the loan is taxed as income. Besides having to pay income taxes, the annuity buyer also pays interest to the insurer, so loans from annuities are not particularly attractive.
When the annuity liquidation phase begins as scheduled, special tax rules apply to annuity distributions provided the income payments meet the Internal Revenue Code requirements to be considered amounts received as an annuity. The requirements are:
By meeting these requirements each income payment is divided into taxable and nontaxable segments. The part that is considered return of premium is not taxed, but the interest portion is taxed. How the taxable portion is calculated is a function of the “exclusion ratio.”
FThe Exclusion Ratio is the proportion of an annuitized payment that is considered as a return of capital and is not taxed.
The exclusion ratio is a percentage determined by dividing all premiums paid for the annuity by the expected benefits:
Total Premiums Paid = Exclusion Ratio
Total Benefits Expected
While some fairly complex rules govern this calculation, the following example describes basically how it works. The IRS provides tables to help determine the expected benefits, using a number called a multiple which is the number of years the annuitant is expected to live (assuming there is only one annuitant). This multiple is applied to the monthly annuity benefit that will be paid and also factors in the age at which the annuitant’s benefits are to begin.
CONSUMER APPLICATION
Tim Foyt has paid $90,000 for an annuity that will pay him $1,000 per month for life beginning at his age 65. The multiple from the IRS table is 20 at age 65 (and would be a different number at other ages). The multiple times the monthly benefit times 12 months equals the expected benefits:
20x$1,000x12 = $240,000
After the expected benefits are calculated, the exclusion ratio is then determined:
37.5% (the exclusion ratio)
This means that of each $1,000 monthly payment Foyt receives, 37.5% or $375 is excluded from taxation. The balance, $625 per month, is taxed as current income. To say it another way, 62.5% of every monthly payment is taxed for this particular person.
The specific numbers that apply to each situation will differ depending upon premiums paid, monthly benefit promised. and the age at which liquidation begins. For Joint annuitants, IRS tables take into consideration the life expectancies of both people at their ages when annuity payments start. Once the exclusion ratio is calculated, that same ratio applies to every payment as long as payments are made.
When an annuity has a death benefit payable to a beneficiary, the exclusion ratio still applies under certain circumstances. If the annuitant dies after payments have begun in the liquidation phase, the beneficiary must receive the death benefit in installments, either on the same schedule as the deceased or faster, in order for the exclusion ratio to be used.
Different rules apply if the annuity owner dies before the liquidation phase begins. If the beneficiary is the spouse of the annuity owner, the spouse is permitted to receive payments on the same schedule the deceased would have received them, using the same exclusion ratio.
The exclusion ratio also applies to distributions to beneficiaries other than the spouse if the death benefit is handled in one of these ways:
If, on the other hand, the survivor simply receives the annuity death benefit as a lump sum, taxes are due on the entire amount that represents interest earned. This results in taxes being due currently on a larger amount than is the case when the exclusion ratio applies.
A death benefit under an annuity may be paid to fulfill a requirement imposed by the Code, or as a pure annuitant death benefit, defined as a benefit triggered by annuitant’s death under the annuity and not required by the tax law. If death benefits are paid in a lump sum, the distribution is taxed in the same manner as a full surrender. If a death benefit is paid according to an annuity option, then the distribution is taxed as :an amount received as an annuity. However, if periodic payments are made in full discharge of the obligation of the insurer under the annuity, the FIFO (First In – First Out) rule applies.
Death benefit payments under an annuity are not eligible for exclusion from gross income. This includes death benefits that exceed the contract’s cash surrender value at death, including “enhanced death benefits” payable under variable annuities. Also, as discussed elsewhere, even though the death benefit is paid upon the death of the owner of the contract, the “investment in the contract” is not “stepped-up” as contrasted with the treatment of the tax basis of other kinds and forms of property passed on to heirs at death.
Conversely, a death benefit paid under a term life insurance rider issued in conjunction with an annuity, may be eligible for the tax exclusion from gross income. In order to qualify for this, the death benefit must be paid under a rider that is economically independent of the annuity and separately constitutes life insurance under IRS rules. Further, since the rider is considered as separate from the annuity, any amount that is taken from the annuity’s value to pay for the life insurance rider would be includible in income in the same manner as a partial withdrawal.
The recipient of a death benefit payment or payments from an annuity may be eligible for an income tax deduction related to the inclusion of the value of the annuity in the decedent’s estate for federal estate tax purposes.33
The IRS Code Section 72(s) provides that a contract will not be treated as an annuity contract for federal tax purposes unless (with certain designated exceptions) it provides for certain distributions in the event that the holder of the contract dies. This means that if the 72(s) requirements are not met, the deferral of income tax that usually applies to an annuity will not be available and there will be current taxation of the inside buildup in the contract. While these regulations apply more to the insurance company, it is wise to be acquainted with these provisions and could prove helpful in discussions regarding that taxation of annuities.
These requirements are rather extensive, but basically they are as follows:
Post-annuitization. The contract must provide that if any holder dies on or after the starting date of the annuity and prior to the time that the entire interest in the contract has been distributed, the remaining portion of such may be accelerated but may not slow down - such as extending the period of which payments may be made, or change in the pattern of payments.
During Deferral Stage. The annuity must provide that if any holder dies before the annuity starting date, the entire interest in the contract will be distributed within 5 years after the holder’s death. There are certain exceptions to this:
This Code goes deeper into various definitions for the purpose of the Code but is not really pertinent to this discussion.
According to a recent Gallup pole, there are approximately $1 trillion in annuity assets, and further, many estimate that more than 80% of these assets are to be part of a parent’s legacy for their children. Obviously, as annuity owners continue to accumulate assets in their tax deferred annuities, the tax liabilities are increasing. The typical solution has been to annuitize the annuities in force, over a five to seven years, into a life insurance contract with income tax-free death benefits. Even though this would appear to be a good plan, exceptional sales have not occurred, and possibly because the clients are trying to avoid income taxes – not accelerate them.
Often retired persons will purchase a deferred annuity in order to avoid current income taxes but the end result is passing the taxes on to their heirs. While the heirs may have more money as an inheritance, many times they will have tax problems of their own. Practically speaking, those individuals who have tax concerns and use an annuity to transfer tax risk are usually wealthier individuals, but generally their heirs are also well-off. In this case it might just be easier to not purchase the annuity.
If the parents want to leave money to their heirs in an annuity, if they are afraid that there will be overwhelming taxation when the annuity is distributed, or if they want to avoid paying taxes in today’s dollars, then the possibility might be an annuity “that pays it own taxes.” This is a very new innovation, so new that there is a patent pending on a version of this plan!
This is a relatively new concept and simply put, it is usually an annuity with a term rider equal in amount to 28% of the gain in the contract. The term insurance provides an increasing death benefit, and a plan with guarantee issue age up to age 90 can be used. The cost of the insurance is taxable to the owner of the annuity each year, thereby making the death benefit income-tax-free.
This can best be explained by example. Assume that a 65 year-old purchases an annuity with a premium of $100,000. After the annuity has been in force for 10 years, the annuity owner dies and passes $200,000 (his original “investment” into the annuity has doubled) to his children. Assuming the children are in the 28% income tax level, they would have to pay $28,000 income tax on $100,000 in the annuity gain. (No tax on the amount invested originally)
Using the term-rider concept, the rider would pay the beneficiaries $28,000 income tax-free to offset the taxes. Therefore, the children inherit the entire $200,000 (instead of $172,000).
To further illustrate this idea, other scenarios can be used. If the client has an annuity paying 6% interest, with no term rider, the beneficiaries will pay taxes on that 6% at the 28% rate. In effect, this is netting 4.32%. If the term rider is used, then the beneficiaries would net the full 6%. When the term rider is added to the annuity, not only does the retiree get the benefits of tax deferral, but the beneficiaries also are collecting the full 6%.
Another scenario might be a client with a large municipal bond portfolio yielding 6%, (admittedly a high rate in today's market). Since 6% interest is accumulating tax free, what benefit is there to purchase a tax-deferred annuity? If the retiree is drawing Social Security, the municipal bond interest is added back into the tax-payer's tax return for "taxable Social Security" purposes. So the result would probably still be that they would be better off using the annuity + term rider program.
In order to pass the test of legality, the contract would specify a separate non-annuity benefit, for which there is a premium deducted for the cost of insurance. The taxpayer pays taxes on the cost of insurance.
According to an IRS private letter ruling33A, the IRS classifies a rider sold with a deferred annuity contract, which provides a term life insurance benefit, as a separate life insurance contract within the meaning of Section 7702. As a result, the IRS private letter ruling concludes that the proceeds payable under the rider on the death of the insured are excludable by the beneficiary under Section 101(a)(1) as life insurance proceeds.
Since this is a new concept, there only a few products available at this time, and there are two separate types. One group is the type of rider as described above. Another type is the rider that adds an annuity of 28% or 40% bonus.
This second type incurs an additional taxable gain. Using the example above of the $100,000 annuity with $100,000 gain, after the bonus, the beneficiaries would pay tax on $128,000. If the beneficiaries were in the 28% bracket, they would receive a net of $92,160. While $92,160 is better than the $72,000 the beneficiaries would have received with no rider, it still is almost $8,000 less than they could have received from the tax-free term rider.
Regardless of the “name” of these products, they still remain an annuity with a term rider. Probably there will be efforts to generate greater benefits to the client using term riders. One suggestion has been accelerated death benefits, which would provide the client with the ability to receive part of the term insurance in the event of terminal illness or long-term care needs.
Another idea would make the beneficiary of the annuity/term-rider a charity. The charity would receive 100% of the annuity value plus the bonus, thereby creating a significant income or estate tax deduction.
New Federal Tax legislation and the generation skipping transfer tax are phased out gradually starting in 2002 and will be totally eliminated by 2010 – provided politics does not interfere. This law will expire in 2010 unless repealed prior to that date.
The value of the annuity at the time of death must be included in the annuitant’s estate in proportion to the amount the deceased person personally contributed to the premiums that bought the annuity. The value of the annuity is the accumulated cash value to date if the individual dies before the liquidation phase begins. After liquidation payouts have begun, the insurance company determines the value of the annuity at the time the annuitant died.
The determination of how much of the annuity’s value must be included in the estate for federal estate taxation must be made. If the annuitant had paid 100% of the premiums, 100% of the annuity value would go into the estate. On the other hand, if the annuitant had paid 50% and someone else had paid 50% of the premiums, only 50% of the annuity value would be included in the estate.
The 1997 tax laws reduced capital gains taxes to a maximum of 20% which was welcomed by most investors, however for those who were considering investing in annuities, this made it a little more difficult.
One of the difficulties of annuity taxation has always been that any withdrawal except for principal are subject to ordinary income taxation. As indicated in this text, the only way(s) to avoid this is to annuitize the contract when a portion of each payment is considered principal and is tax-free for that portion; “wait it out” on the hopes that tax brackets may drop or the person may be in a lower tax bracket at annuitization; bequeath the annuity to a spouse who would probably be in a lower tax bracket; or let the kids suffer by not taking any withdrawals and leave it all up to the kids to receive the funds and have to pay taxes on them.
Still, since nearly all of the investments that are not annuities have their interest taxed each year, and fully, (except for municipal bond interest or sheltered by depreciation), annuities have a distinct advantage in that respect. Growth from any of these “non-annuities” is taxed only if the investment is sold at a profit, and unlike an annuity, the sale of the investment is never required. An annuity must be liquidated completely within 5 years after the death of the contract owner’s surviving spouse (or the owner’s death if he/she is single at death). This is the problem with annuities in this regard – there is no step-up in basis upon death.
“Step-up” may be best explained by illustration. If John dies, most of his assets get a “step-up” in basis, meaning that heirs receive the assets, for purposes of income tax, as if John’s heirs had purchased the assets on the day that John died for the “fair-market value” as of that date. Therefore, if one of John’s heirs sold any asset, any gain or loss would be based on the inherited value and not the price that John paid for the investment when he was alive.
To reiterate, certain assets do not get a step-up in basis upon death, and that includes annuities, Certificates of Deposit, money market funds & qualified retirement plans. The heir must pay taxes on an ordinary income basis when the funds are liquidated. The taxable portion is the difference between the selling price and the purchase price (or purchase price plus dividends, capital gains, and/or interest that had been automatically invested each year) – except for qualified retirement accounts where everything is taxable when withdrawn except for the money that was contributed on an after-tax basis, i.e., not deductible when invested.
The question may arise as to whether the gift of a nonqualified annuity contract or annuity payments, subject to federal gift tax. The answer is “yes.” The gift of a nonqualified annuity or annuity payments is subject to the federal gift tax if the gift is complete.34 When a donor makes a complete gift of an annuity contract, the donor gives up all of his rights in the contract. Conversely, the complete gift of an annuity payment or payments may allow the donor to retain an interest in the contract, such as a death benefit payment or future annuity payments. Therefore, the gift tax may apply when a donor gifts (1) an entire annuity contract, or (2) a series of annuity payments, or (3) a single annuity payment.
If the gift is complete, gift tax rules will apply as they generally do to other forms of property. A taxpayer may gift up to $11,000 or $22,000 for married couple (in 2002) to each of an unlimited number of donees without attracting gift tax to the donor or tax income to the donee.35 If a gift is made in excess of the exclusion amount, the donor must either pay gift tax on the excess or decrease the amount of the unified credit available to the donor under the estate tax.
If ownership rights in a nonqualified annuity contract are transferred at death, the value of such contract ownership - which includes any annuity payment continuing after death – are includible in the deceased owner’s estate for federal estate tax purposes.37
Any amounts so included will be taxable under the applicable estate tax rate to the extent that such amounts exceed the level offset by the unified estate tax credit.
Under the unified credit, each taxpayer may exclude a statutorily prescribed amounts, such as $1.5 million for 2004 and 2005, from the taxpayers taxable estate. The unified credit will be increased in gradual increments until it reaches $3.5 million in 2009.37A [IRC 2010(c)]
If a nonqualified annuity is included in a deceased owner’s estate for federal estate tax purposes, the person who inherits the annuity does not receive a stepped-up basis. Instead, that person’s basis is the same as the basis of the deceased owner.38 There are special rules involved as to the taxation of amounts payable after the owner’s death.
This text addresses the simpler aspects of annuity taxation. Tax laws can be quite complex when a particular type of annuity is used in any given case since different people have a variety of personal, business and financial situations that can affect taxation. Professional counsel is always recommended for determining the tax consequences of financial transactions.
STUDY QUESTIONS
1. The premiums that an individual pays for a nonqualified annuity
A. are not tax deductible for federal income tax purposes.
B. are tax deductible for federal income tax purposes.
C. are subject to gift taxes.
D. only subject to state premium taxes, and occasionally, sales taxes.
2. During the accumulation period, qualified or non-qualified annuity values
A. are taxed every year as ordinary income.
B. are taxed on a capital gains basis.
C. build on a tax-deferred basis.
D. build on a tax-free (forever) basis.
3. Distributions that are made in installments are
A. never taxed.
B. taxed as ordinary income in the year they are received.
C. cumulatively taxed each 2 years.
D. taxed at a capital gains rate.
4. When an annuity is surrendered or a partial withdrawal is made, then all annuities issued by the same insurance company to the same policyholder during any calendar year, are to be considered as a single contract. This is called
A. the Annuitization Rule.
B. a voidable transaction.
C. the Aggregation Rule.
D. subrogation.
5. An annuity distributed from a qualified plan can have income tax postponed by converting the annuity into a nontransferable annuity immediately. This is called
A. a 401(k) rollover.
B. an ERISA rollover.
C. a 1035 Exchange.
D. the substitution rule.
6. Under the IRS guidelines, there is a penalty for early withdrawals, which means
A. there is an added tax on annuity distributions prior to age 75.
B. there is an added tax on annuity distributions prior to age 59 ½.
C. no benefits may be withdrawn tax free at any time.
D. that it is imposed in addition to the income tax otherwise due.
7. For tax purposes, a loan from an annuity (which is rare) is treated
A. as a tax-free exchange.
B. as total annuitization so taxes are due on the entire annuity values.
C. as the receipt of current income.
D. as a hardship disbursement, so it is not taxed until the annuity annuitizes.
8. The proportion of an annuitized payment that is considered as a return of capital and is not taxed, is
A. the Accumulation rule.
B. the Exclusion Ratio.
C. partial annuitization.
D. an illegal attempt to avoid taxes.
9. If the annuitant dies after payments have begun in the liquidation phase, the beneficiary must receive the death benefit in installments, either on the same schedule as the deceased or faster
A. for the above (question 8) to be used.
B. and the entire amount of the payment is taxed as ordinary income to the beneficiary.
C. there are no taxes due at any time for the beneficiary to pay.
D. and the annuity value is doubled if the death is accidental.
10. IRS Code Section 72(s) provides that a contract will not be treated as an annuity contract for federal tax purposes unless it provides for certain distributions in the event that the holder of the contract dies. This means that if this Code is not met
A. the income tax deferral of an annuity will not apply.
B. the income tax deferral of an annuity will apply just the same.
C. the contract will be considered void ab initio and the insurer must return all premiums.
D. the IRS will abscond with the annuity values.
ANSWERS TO STUDY QUESTIONS
1A 2C 3B 4C 5C 6D 7C 8B 9A 10A