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.
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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.