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Federal Income Tax And Guaranteed VA Withdrawals: What To Know

By Joseph F. Mckeever

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The debut of new and valuable guaranteed benefits in variable annuities presents new tax issues to consider.

A decade ago, for instance, new and enhanced forms of guaranteed death benefits took center stage, and those benefits raised some significant tax issues.

One area concerned the addition to IRA annuities of various types of death benefits, beyond the simple return of the greater of account value or net premiums paid. This initially caused the Internal Revenue Service to take the informal position that such benefits could not be offered on IRA annuities–because, in the minds of some, the death benefits were a form of life insurance and IRAs cannot invest in life insurance.

Over time, IRS and Treasury Department officials came to the correct conclusion: these benefits were not life insurance. However, they also recognized that these benefits have economic value to the annuity owner.

As a result, we now have a set of rules for IRA annuities (as well as 403(b) and other annuities used in qualified retirement plans). The rules allow death benefits to be part of an IRA annuity, but also mandate inclusion of the death benefit value in the calculation of required minimum distributions from the deferred annuity.

Today, VA “living benefits” are the guarantees that have taken center stage – e.g., guaranteed withdrawal benefits, guaranteed accumulation benefits, guaranteed minimum income benefits and guaranteed withdrawal benefits for life. And the pattern still holds: The new guaranteed living benefits can raise some interesting tax issues. Two of them are highlighted here.

1) The Section 72(s) Distribution at Death Rules: Since 1985, the Internal Revenue Code has required that all non-qualified annuities incorporate rules requiring that, if the owner dies before the “annuity starting date,” the “entire interest” in the contract be distributed to the beneficiary within 5 years. Alternatively, if distributions begin within 1 year of death, the owner’s interest may be distributed over the life or life expectancy of the beneficiary. (A surviving spouse can continue the contract.)

These rules can present a design challenge for some guaranteed withdrawal benefits. This is because such benefits are priced based in part on incorporating specific limits on annual withdrawals, while the section 72(s) rules are designed to force the owner’s entire interest in the contract out over a limited period.

To illustrate, consider a benefit that guarantees payment of a benefit base (e.g., net premiums paid), as long as no more than 5% of the benefit base is withdrawn in a year. In effect, the benefit guarantees return of the premiums paid for the contract over 20 years irrespective of investment performance. Now assume the issuer wishes to allow a non-spouse beneficiary to “inherit” the benefit if the owner dies (certainly a consumer-friendly design).

If the owner dies before the annuity starting date, the owner’s entire interest must be distributed over a period no greater than the beneficiary’s life expectancy. If the beneficiary has a life expectancy of less than 20 years, e.g., 10 years, can the issuer afford to distribute the entire benefit base at a rate of 10% per year? Or will the issuer need to limit the availability of the benefit to beneficiaries with life expectancies at the time of the owner’s death of over 20 years?

In either event, the issuer now faces another dilemma. Section 72(s) requires that the owner’s entire interest in the contract be distributed over a period not exceeding the beneficiary’s life expectancy. Assume the beneficiary has a life expectancy of more than 20 years, the cash value at death is $1,000 and the benefit base is $2,000. Is it sufficient to be distributing only the annuity’s cash value over the beneficiary’s life expectancy? Or do the annual post-death distributions need to account in some manner for the value associated with the guaranteed withdrawal benefit that the beneficiary has also inherited?

2) Determination of Income on a Partial Withdrawal: Since 1982, withdrawals before the annuity starting date from a non-qualified annuity have been includible in income to the extent of the “income on the contract.” The income on the contract equals the excess of “cash value of the contract (determined without regard to any surrender charge)” over the taxpayer’s investment (effectively premiums paid less non-taxable withdrawals).

The issues this rule raises when guaranteed living benefits are added to a contract can be seen in this example:

Assume a VA minimum accumulation benefit. It guarantees that at end of year 10, the accumulation value will reset to a benefit base equal to net premiums paid, compounded at 5% annually, if greater than actual accumulation value. Before year 10, the benefit is not payable in any form. In contract year 2:

o Net premiums paid and investment in the contract equal $100.

o Cash value (before surrender charges) equals $105.

o Benefit base equals $111.

o Owner takes a withdrawal of $10.

So, how much of the $10 withdrawal is includible in income?

The possible answers include:

o $5 ($5 is the income on the contract because it’s the amount by which the stated cash value ($105) exceeds basis ($100)).

o $10 (on the theory that the benefit base is the “cash value,” and thus there is $11 of income on the contract).

o Some amount greater than $5 but less than $10 (on the theory that the stated cash value should be increased by some part of the current accumulation benefit value).

I think the better answer is $5, because the IRC refers to a contract’s “cash value,” and the benefit base is not part of the cash value as that term is widely and correctly understood. However, should the answer be the same if the facts are identical except that the withdrawal occurs two days before 10th contract anniversary? Technically, yes, but one can appreciate that policymakers might question that result.

The two issues discussed here simply illustrate the point that, as product design advances, new tax questions (or old questions in new forms) typically will arise. However, with careful planning to minimize tax risks and disclosures to policyholders where the uncertainty cannot be eliminated, there is no reason customers cannot enjoy the increased protections that innovative guaranteed benefits offer.