The Internal Revenue Service says heirs of deferred annuity holders may have to pay income taxes on a portion of some annuity death benefit payments.[@@]

The decision, given in IRS Revenue Ruling 2005-30, will affect customers who have bought deferred annuities after Oct. 21, 1979, and die unexpectedly early.

If the annuity holder dies early, before the life insurance company that issued the annuity starts making annuity income payments, then the annuity holder’s beneficiaries must include part of the annuity death benefits in their taxable gross income, according to Bradford Poston, an IRS passthroughs and special industries specialist.

The beneficiaries can exclude an amount equal to the annuity holder’s investment in the contract from taxable income, but the beneficiaries must report any additional annuity death benefits as “income in respect of a decedent,” Poston writes.

“The result would be the same whether [the beneficiary] receives the death benefit in a lump sum or as periodic payments,” Poston writes.

An earlier revenue ruling, Revenue Ruling 1979-335, held that beneficiaries had to include lump-sum deferred annuity death benefit payments in gross income but could exclude annuitized death benefit payments.

Poston says the 1979 ruling fails to deal with the tax treatment of death benefit amounts that exceed the annuity purchaser’s investment in the contract. The extra death benefits should be taxable because, if the annuity holder had surrendered the contract while alive, the annuity holder would have had to pay taxes on the extra cash, Poston writes.

The IRS has posted the revenue ruling on the Web at http://www.irs.gov/pub/irs-drop/rr-05-30.pdf