The Advisor's Professional Library

Annuities: Variable Annuities

March 4, 2013

1 Free Preview Remaining

You have used 1 of 2 free previews from The Advisor's Professional Library

Is the purchaser of a deferred variable annuity taxed on the annual growth of a deferred annuity during the accumulation period?

An annuity owner who is a “natural person” will pay no income tax until he or she receives distributions from the contract. If the contract is annuitized, taxation of payments will be calculated based on the rules that apply given the annuity starting date when payments begin. Distribution amounts received “not as an annuity” prior to the annuity starting date are subject to additional rules.

The tax deferral enjoyed by a deferred annuity owned by a natural person is not derived from any specific IRC section granting such deferral. Rather, this tax treatment is granted by implication. All distributions from an annuity are either “amounts received as an annuity” or “amounts not received as an annuity.” As the annual growth of the annuity account balance, except to the extent of dividends, is not stated in the IRC to be either, it is not a “distribution,” and therefore is not subject to tax as earned. 

A variable annuity contract will not be treated as an annuity and taxed as explained in this and the following questions unless the underlying investments of the segregated asset account are “adequately diversified,” according to IRS regulations.[1]

If the owner of the contract is a person other than a natural person (for example, a corporation), growth in the value of the annuity might not be tax deferred.


[1] .IRC Sec. 817(h); Treas. Reg. §1.817-5.


How is the value of a refund or period-certain guarantee determined under a variable annuity contract?

If a variable annuity settlement provides a refund or period-certain guarantee, the investment in the contract must be reduced by the value of the guarantee before being prorated for the yearly exclusion.[1] The value of such a guarantee in connection with a single life annuity is determined as follows:

Find the refund percentage factor in Table III or Table VII (whichever is applicable, depending on the date the investment in the contract was made under the age and (if applicable) sex of the annuitant and the number of years in the guaranteed period. Where the settlement provides that proceeds from a given number of units will be paid for a period-certain and life thereafter, the number of years in the guaranteed period are clear (e.g., ten, fifteen, twenty “years certain”).

If the settlement specifies a guaranteed amount, however, divide this guaranteed amount by an amount determined by placing payments received during the first taxable year (to the extent that such payments reduce the guaranteed amount) on an annual basis. Thus, if monthly payments begin in August, the total amount received in the first taxable year is divided by five, then multiplied by twelve.

The quotient is rounded to the nearest whole number of years, and is used in entering Table III or Table VII, as applicable. The appropriate Table III or Table VII multiple is applied to whichever is smaller: (a) the investment in the contract, or (b) the product of the payments received in the first taxable year, placed on an annual basis, multiplied by the number of years for which payment of the proceeds of a unit or units is guaranteed. The following illustration is taken from the regulations:[2]

Example: Mr. Brown, a fifty year old male, purchases for $25,000, a contract that provides for variable monthly payments to be paid to him for his life. The contract also provides that if he should die before receiving payments for fifteen years, payments shall continue according to the original formula to his estate or beneficiary until payments have been made for that period. Beginning with the month of September, Mr. Brown receives payments that total $450 for the first taxable year of receipt. This amount, placed on an annual basis, is $1,350 ($450 divided by 4 or $112.50; $112.50 multiplied by 12, or $1,350).

If there is no post-June 1986 investment in the contract, the guaranteed amount is considered to be $20,250 ($1,350 × 15), and the multiple from Table III (for male fifty, fifteen guaranteed years), nine percent, applied to $20,250 (because this amount is less than the investment in the contract), results in a refund adjustment of $1,822.50. The latter amount, subtracted from the investment in the contract of $25,000, results in an adjusted investment in the contract of $23,177.50. If Mr. Brown dies before receiving payments for fifteen years and the remaining payments are made to Mr. Green, his beneficiary, Mr. Green shall exclude the entire amount of such payments from his gross income until the amounts so received by Mr. Green, together with the amounts received by Mr. Brown and excludable from Mr. Brown’s gross income, equal or exceed $25,000. Any excess and any payments thereafter received by Mr. Green shall be fully includable in gross income.

Assume the total investment in the contract was made after June 30, 1986. The applicable multiple found in Table VII is three percent. When this is applied to the guaranteed amount of $20,250, it results in a refund adjustment of $607.50. The adjusted investment in the contract is $24,392.50 ($25,000 - $607.50).


[1] .Treas. Reg. §1.72-7(d).
[2] .Treas. Reg. §1.72-7(d)(2).

 

If payments from a variable annuity drop below the excludable amount for any year, is the balance of the exclusion lost? 

No.

If the amount received in any taxable year is less than the excludable amount as originally determined, the annuitant may elect to redetermine the excludable amount in a succeeding taxable year in which the annuitant receives another payment. The aggregate loss in exclusions for the prior year (or years) is divided by the number of years remaining in the fixed period or, in the case of a life annuity, by the annuitant’s life expectancy computed as of the first day of the first period for which an amount is received as an annuity in the taxable year of election. The amount so determined is added to the originally determined excludable amount.[1]

Example 1: Mr. Brown is sixty-five years old as of his birthday nearest July 1, 1985, the annuity starting date of a contract he purchased for $21,000. There is no investment in the contract after June 30, 1986. The contract provides variable monthly payments for Mr. Brown’s life. Because Mr. Brown’s life expectancy is fifteen years (Table I), he may exclude $1,400 of the annuity payments from his gross income each year ($21,000 ÷ 15). Assume that in each year before 1988, he receives more than $1,400, but in 1988, he receives only $800 – $600 less than his allowable exclusion. He may elect, in his return for 1989, to recompute his annual exclusion. Mr. Brown’s age, as of his birthday nearest the first period for which he receives an annuity payment in 1989 (the year of election) is sixty-nine, and the life expectancy for that age is 12.6. Thus, he may add $47.61 to his previous annual exclusion, and exclude $1,447.61 in 1989 and subsequent years. This additional exclusion is obtained by dividing $600 (the difference between the amount he received in 1988 and his allowable exclusion for that year) by 12.6.

Example 2: Mr. Green purchases a variable annuity contract that provides payments for life. The annuity starting date is June 30, 2010, when Mr. Green is 64 years old. Mr. Green receives a payment of $1,000 on June 30, 2011, but receives no other payment until June 30, 2013. Mr. Green’s total investment in the contract is $25,000. Mr. Green’s pre-July 1986 investment in the contract is $12,000. Mr. Green may redetermine his excludable amount as above, using the Table V life expectancy. If, instead, he elects to make separate computations for his pre-July 1986 investment and his post June-1986 investment, his additional excludable amount is determined as follows.

Pre-July 1986 investment in the contract allocable to taxable years 2011 and

 

2012 ($12,000 ÷ 15.1 [multiple from Table I for a male age 64] = $794.70;

$1,589.40

Less: portion of total payments allocable to pre-July 1986 investment in the

 

contract actually received as an annuity in 2011 and 2012 ($12,000/$25,000

 

      x $1,000)

480.00

      Difference

$1,109.40

Post-June 1986 investment in the contract allocable to taxable years 2011 and

 

2012 ($13,000 ÷ 20.3 [multiple from Table V for male age 64] = $640.39; $640.39 x 2 years = $1,280.78

$1,280.78

Less portion of total payments allocable to post-July 1986 investment in the

 

contract actually received as an annuity in 2011 and 2012 ($13,000/$25,000

 

      x $1,000)

520.00

      Difference

$ 760.78

   

 Because the applicable portions of the total payment received in 2011 under the contract ($480 allocable to the pre-July 1986 investment in the contract and $520 allocable to the post-June 1986 investment in the contract) do not exceed the portion of the corresponding investment in the contract allocable to the year ($794.70 pre-July 1986 and $640.39 post-June 1986) the entire amount of each applicable portion is excludable from gross income and Mr. Green may redetermine his excludable amounts as follows:

Divide the amount by which the portion of total payment actually received allocable to pre-July 1986 investment in the contract is less than the pre-July 1986 investment in the contract allocable to 2011 and 2012 ($1,109.40) by the life expectancy under Table I for Mr. Green, age 66 (14.4 - .5 [frequency multiple]; $1,109.40 ÷ 13.9)

$ 79.81

Add the amount originally determined with respect to pre-July 1986 investment in the contract

794.70

Amount excludable with respect to pre-July 1986 investment

$874.51

Divide the amount by which the portion of total payment actually received allocable to post-June 1986 investment in the contract is less than the post-June 1986 investment in the contract allocable to 2011 and 2012 ($760.78) by the life expectancy under Table V for Mr. Green, age 66 (19.2 - .5 [frequency multiple]; $760.78 ÷ 18.7)

$ 40.68

Add the amount originally determined with respect to post-June 1986 investment in the contract

640.39

Amount excludable with respect to post-June 1986 investment

$681.07

   

 


[1] .Treas. Reg. §1.72-4(d)(3).

 

What is a wraparound or investment annuity? How is the owner taxed prior to the annuity starting date?

Investment annuity and wraparound annuity are terms for arrangements under which an insurance company agrees to provide an annuity funded by investment assets placed by or for the policyholder with a custodian or by investment solely in specifically identified assets, such as XY Mutual Fund, held in a segregated account of the insurer. The IRS has ruled that under these arrangements, sufficient control over the investment assets is retained by the policyholder so that income on the assets prior to the annuity starting date is currently taxable to the policyholder rather than to the insurance company.[1]

In some instances, however, the policyholder’s degree of control over the investment decisions has been insufficient, so the IRS considered the insurance company, rather than the policyholder, to be the owner of the contracts. For example, the IRS has ruled that the contract owner of a variable annuity can invest in sub-accounts that invest in mutual funds that are available only through the purchase of variable contracts without losing the variable annuity’s tax deferral.[2]

The IRS has ruled on whether the “hedge funds” within the sub-accounts of variable annuities and variable life insurance contracts will be treated as owned by the insurance company or the contract owner. Generally, if the hedge funds are available to the general public, the sub-account will be treated as owned by the contract owner and therefore not entitled to tax deferral. However, if the hedge funds are available only through an investment in the variable annuity, tax deferral is available.[3] The IRS also has clarified who is considered the “general public.”[4]

With the exception of certain contracts grandfathered under Revenue Rulings 77-85 and 81-225, the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in the Regulations.[5]


[1] .Christoffersen v. U.S., 84-2 USTC ¶9990 (8th Cir. 1984), rev’g 84-1 USTC ¶9216 (N.D. Iowa 1984), cert. denied, 473 U.S. 905 (1985); Rev. Rul. 81-225, 1981-2 CB 12 (as clarified by Rev. Rul. 82-55, 1982-1 CB 12); Rev. Rul. 80-274, 1980-2 CB 27. Rev. Rul. 77-85, 1977-1 CB 12.
[2] .Rev. Rul. 2005-7, 2005-6 IRB 464. See also Rev. Rul. 2003-91, 2003-33 CB 347; Rev. Rul. 82-54 1982-1 CB 11.
[3] .Rev. Rul. 2003-92, 2003-33 CB 350.
[4] .Rev. Rul. 2007-7, 2007-7 IRB 468.
[5] .IRC Sec. 817(h); Treas. Reg. §1.817-5.

 

What is a longevity annuity?

The IRS has issued a private letter ruling explaining the tax treatment of a so-called longevity annuity.[1] According to the IRS, a longevity annuity is an annuity contract that provides no cash value or death benefits during the deferral period. On the deferral period end date, the contract’s contingent account value becomes the cash value and is accessible by the owner through:

(1) the right to receive annuity payments at guaranteed rates,

(2) the right to surrender the contract for its cash value,

(3) the right to take partial withdrawals of the cash value, and

(4) a death benefit.

The IRS concluded that a longevity annuity is an annuity contract for purposes of IRC Section 72 because the contract is in accordance within the customary practice of life insurance companies and the contract does not make periodic payments of interest.

In support of its first conclusion, the IRS noted that insurance companies historically have issued deferred annuity contracts that, like longevity annuities, did not have any cash value during the deferral stage and did not provide any death benefit or refund feature should the annuitant die during this time. Thus, in the IRS’s opinion, survival of the annuitant through the deferral period is not an inappropriate contingency for the vesting of cash value and the application of annuity treatment to the proposed contract.

In reaching the second conclusion, the IRS took note of the fact that the longevity annuity provides for periodic payments designed to liquidate a fund, contains permanent annuity purchase rate guarantees that allow the contract owner to have the contingent account value applied to provide a stream of annuity payments for life or a fixed term at any time after the deferral period, and provides for payments determined under guaranteed rates.


[1] .Let. Rul. 200939018.

Tax Facts Online

Summit Professional Networks

Tax Facts Online, a service of Summit Professional Networks, is the online version of Tax Facts, which during its more than 50-year history has become the industry standard for clear, up-to-date and thorough tax information. Now in an all-inclusive online format, every answer, ruling and table is easier than ever to find. Tax Facts Online delivers the same trusted information as the time-tested Tax Facts Source Books with the benefits of robust search power, interactive calculatorsand tables, copy/paste capability, and daily updates as changes occur.