Preserving Investment in an Annuity Contract

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When your clients roll over a retirement account into an annuity, stay alert. They could lose significant tax benefits if they don’t document their investment in the contract.

Gains realized on surrender of an annuity are taxed as ordinary income, but the entire amount received on surrender might not be taxed, since a taxpayer is entitled to receive his or her investment in the contract back tax-free.

Keeping track of investment in the contract is simple enough when a person pays premiums out a checking account into the annuity—the total amount of the premiums will constitute investment in the contract. But when a rollover is made from a pre-tax retirement account like an IRA, things get more complicated, and documenting investment in the contract is essential to preserve its tax benefit.

The Tax Court recently considered whether a taxpayer was entitled to exclude the amount received on surrender of an annuity from gross income where the taxpayer failed to document his investment in the contract as funds moved between an employer savings plan, an IRA and into an annuity, James D. and Bobbie Rogers v. Commissioner, No. 25365-09S (2011).

The Facts

James Rogers was employed by Lockheed Martin, where he participated in an employer-sponsored savings plan. He contributed 8% of his after-tax salary into the savings plan. Lockheed also made contributions to the plan. Rogers retired in 2003 and the funds in the plan were transferred to a money market fund.

Later that year, Rogers withdrew $16,000 from the money market fund, leaving a balance of $71,995. He then rolled the remaining funds into an annuity—the rollover was characterized as an IRA rollover.

Rogers made a series of withdrawals from the annuity, including a $7,000 withdrawal in 2004, a $5,000 withdrawal in 2005, $6,500 in withdrawals in 2006, and $10,000 in 2007. He surrendered the annuity in 2008, receiving $59,231 in 2008.

The Tax Returns

The 1099-R forms James Rogers received in 2004, 2005, and 2006 indicated that federal and state income taxes were withheld at the time of the withdrawals. But his 2007 Form 1099-R showed that he had elected not to have federal or state income tax withheld from the $10,000 withdrawal. Although the Rogers filed a joint return for 2007, they did not report the $10,000 withdrawal, and the IRS determined that the $10,000 withdrawal should have been included in gross income and issued a notice of deficiency, saying that the couple owed an additional $1,500.

The Tax Court’s Decision

Under the Tax Code, gross income is “all income from whatever source derived.” That includes amounts received from an annuity or IRA. A taxpayer’s basis in an asset will reduce taxable income, but generally, taxpayers have zero basis in an IRA.

In some instances, a taxpayer might have basis in an IRA. A taxpayer has basis in an IRA to the extent of nondeductible contributions they have made to the IRA, minus any withdrawals and distributions of previously taxed contributions. But nondeductible contributions to an IRA must be reported annually, and taxpayers must keep copies of all forms relating to their nondeductible contributions in order to preserve the tax characteristics of those contributions.

James Rogers claimed that the $10,000 withdrawal was not includable in gross income because the funds initially placed in the annuity were allocable to previously taxed contributions he made into his Lockheed savings plan. But the court concluded that Rogers had contributed at most $5,926 in after-tax dollars to the savings plan. The next issue for consideration was whether James Rogers could substantiate that the $5,926 amount was not distributed to him from the account before the funds were rolled over into the annuity, which would have depleted his investment in the contract.

According to the annuity contract, Rogers' deposit into the annuity came from untaxed earnings. And Rogers provided incomplete documents at trial. Although the IRS acknowledged that the documents supported Rogers’ assertion that he had made some after-tax contributions to his Lockheed savings plan, the court agreed that Rogers had failed to identify, or trace the nondeductible contributions to any funds remaining in the plan.

The court said Rogers failed to establish that the withdrawals he made did not deplete his investment in the employer savings account through withdrawals. As a result, it held that Rogers was fully taxable for any withdrawals from the annuity.

Conclusion

The takeaway from the case is clear: As funds make their way through a series of accounts, it is essential to keep track of nondeductible contributions, which add to the taxpayer’s investment in the contract and will eventually reduce their tax liability when they take distributions from the accounts or annuities.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.

See also The Law Professor's blog at AdvisorFYI.

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