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Planners: Address What Happens When The Annuity Owner Dies

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One of the frequent complaints that critics of annuity contracts have is that investment gains are tax-deferred, not tax-free as would be the case with life insurance proceeds or interest paid on municipal bonds.

Moreover, the value of the annuity contract may be includible in the estate of the owner and be subject to inclusion in his or her estate at death.

Owners of annuity contracts and the financial professionals who advise them, should be aware of techniques that can help ameliorate these potential taxes.

Only a few financially fortunate individuals will amass enough assets during a lifetime to become subject to payment of estate taxes or generation-skipping transfer taxes. For those who are likely to have estate or generation-skipping transfer tax liability, however, some help may be available.

Specifically, there exists a fortunate interpretation of the tax laws that can help such individuals avoid some of the double taxation that would occur if annuity death proceeds were subject to both federal income taxes and federal estate taxes or generation-skipping transfer taxes.

The Internal Revenue Service has determined that taxpayers receiving distributions from annuity contracts that were subject to estate taxes or generation-skipping transfer taxes can qualify for the application of the tax relief principle know as “income in respect of a decedent.” This concept applies to amounts a decedent was entitled to but that had not been included in income during the year of death.

“Income in respect of a decedent” permits taxpayers to take a deduction from their federal income taxes for certain amounts paid in estate and generation-skipping transfer taxes resulting from distributions from annuity contracts.

When the taxable portion of distribution from an annuity (i.e., the portion that represents the amount of distribution in excess of the basis in the contract) has also been subject to federal estate taxes or generation-skipping transfer taxes, the taxpayer receiving such distribution can take a deduction on the income tax return that will help avoid possible double taxation on annuity distributions.

To do this, the taxpayer computes the federal estate tax or generation-skipping transfer tax with the net amount of the income in respect of a decedent included, and then recalculates the tax with the tax excluded. The taxpayer can then take a deduction on his or her federal income tax return for the difference between the two amounts.

To the extent that the amount that is “income in respect of a decedent” would have been taxable as ordinary income to the decedent, the amount of the permitted deduction is an itemized deduction. Thus, it is subject to whatever limitations may apply to itemized deductions.

Obviously, there may be other disconnects that can result from differences in tax brackets between the income tax and the estate or generation-skipping transfer taxes. But, in general, the availability of the “income in respect of a decedent” deduction helps to avoid double taxation on the same death proceeds.

This makes annuities more appealing purchases to enhance retirement security–particularly for those who have been so fortunate as to accumulate enough wealth to make estate taxes or generation-skipping transfer taxes a problem.

The law requires multiple recipients of death benefit distributions from an annuity contract to apportion the deduction among them.

Likewise, if the distributions take place over a period of tax years, the deduction must be apportioned over the years during which distributions are received.

Use of the tax deduction afforded by the concept of “income in respect of a decedent” can also be combined with other methods to reduce tax brackets and thereby reduce taxes.

For instance, since 1985, all annuity contracts have been required, pursuant to the Internal Revenue Code, to force distributions on the death of an annuity contract owner.

This requirement is mandated in Section 72(s) of the Internal Revenue Code. It specifies that, upon such death, the contract value must be distributed no less slowly than over the five years following death or in the form of annuity payments for the life expectancy of the beneficiary. Such annuity payments must begin within one year of the date of death. (Note: If an annuity contract fails to contain provisions requiring such distribution, it will not qualify as an annuity for tax purposes.)

If the death benefit distributions under an annuity contract qualify for the investment increment to be “income in respect of a decedent,” the combination of the tax deduction and the spreading of the income item over a longer period of time may help reduce the income tax bracket that might otherwise apply to a lump sum distribution.

At the very least, modeling would help to demonstrate the most tax efficient method to take death benefit distributions from an appreciated annuity contract. This is particularly true in view of the fact that the primary purpose of an annuity is to provide insurance against living too long.

It is possible that the combination of lifetime payments combined with possible tax deductions could help guarantee that this primary purpose is accomplished.

This discussion is offered in hope it will reinforce the need for financial planning on the death of the owner of an annuity contract. Most clients would rather have their hard-earned assets transferred to loved ones than have them unnecessarily paid to the government in the form of taxes.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Ft. Lauderdale, Fla., office of Blazzard, Grodd & Hasenauer, P.C. E-mail them at: [email protected]

Reproduced from National Underwriter Life & Health/Financial Services Edition, October 7, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.