Q: If an annuitant dies before his or her deferred annuity matures or is annuitized, is the amount payable at the annuitant’s death subject to income tax?
An annuity contract generally provides that if the annuitant dies before the annuity starting date, the beneficiary will be paid, as a death benefit, the greater of the amount of premium paid or the accumulated value of the contract. The gain, if any, is taxable as ordinary income to the beneficiary. The death benefit under an annuity contract does not qualify for tax exemption under IRC Section 101(a) as life insurance proceeds payable by reason of the insured’s death.
Gain is measured by subtracting (1) investment in the contract from (2) the death benefit plus aggregate dividends and any other amounts that have been received under the contract that were excludable from gross income (Q 355). In addition, death benefits paid on the death of the owner of the annuitant is income in respect of a decedent (“IRD”) to the extent that the death benefit amount exceeds the basis in the annuity contract; as a result, the beneficiary may be eligible for a special income tax deduction for the estate tax attributable to the IRD. The IRS has ruled that an assignment of an annuity from a decedent’s estate to a charity will not cause the estate or its beneficiaries to be taxed on the proceeds of the annuity.
Planning Point: The owner of a non-qualified deferred annuity generally should be named as the annuitant. Where the owner and annuitant are two different individuals, problems can result, especially if the annuity is annuitant-driven. (All annuities issued since 1986 are “owner driven” where a requirement to pay out the cash value is triggered by the death of the owner. Some also are annuitant-driven, where the death benefit is triggered by the death of the annuitant. Some annuitant-driven deferred annuities provide for two death benefits: the guaranteed minimum death benefit, which may exceed the annuity cash value, that is payable upon death of the annuitant, and the cash value itself, which must be paid out on the death of the owner.) If the owner and annuitant are the same person, none of this matters; if they are not, it does. John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.
A deferred annuity that provides the beneficiary with the option to take the death benefit as a lump sum will not be taxed on the gain in the year of death if he or she elects “within 60 days after the day of which such lump sum first became payable” to apply the death benefit under a life income or installment option (Q 394). The periodic payments then will be taxable to the beneficiary under the regular annuity rules (Q 359 to Q 371). The exclusion ratio for the contract will be based on the decedent’s investment in the contract and the beneficiary’s expected return.
What is the meaning of within sixty days after the day of which such lump sum first became payable? Some commentators argue that this means within sixty days of the death that triggered such lump sum (i.e., the death of the annuity owner, in all cases, or, in the case of an “annuitant-driven” annuity, the death of the annuitant). It may be argued, however, that no such lump sum becomes payable until the beneficiary submits proof of such death, together with a claim for the death benefit, to the insurer. Regulation Section 1.451-2(a) states that “income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.” A beneficiary cannot receive payment of a death benefit before it is paid, and an insurer will not make such payment until it receives proof of death and properly completed claim forms. Treasury has provided no definitive guidance on this issue beyond noting that a “timely election” under Section 72(h) is required.
There is a widespread (mis-)belief that the beneficiary of a deferred annuity, where the owner died prior to annuity starting date, has one year, not sixty days, in which to make an election to take the death proceeds as an annuity without becoming in constructive receipt of all contract gain. This mis-belief is grounded in the fact that IRC Section 72(s)(2) provides that no contract issued since January 18, 1985, shall be considered “an annuity” (and taxed as an annuity) unless it provides that “any portion of the holder’s interest” that is payable to a designated beneficiary will be distributed “over the life of such designated beneficiary (or over a period not extending beyond the life expectancy of such beneficiary),” and that “such distributions begin not later than 1 year after the date of the holder’s death or such later date as the Secretary may by regulations prescribe” (Q 397). That provision, however, states only the provisions that an annuity contract must contain (with respect to distributions made on the death of any holder) to be deemed “an annuity” for tax purposes. It does not speak to how long a beneficiary may wait to exercise an annuity payout option without being in constructive receipt of all contract gain; as noted above, IRC Section 72(h) does speak to this. Moreover, Section 72(s) applies only on the death of the holder of an annuity and not when the annuitant of an annuitant-driven contract dies. Some commentators suggest that Section 72(s) “trumps” Section 72(h) because it is newer. The latter section, however, has not been repealed or amended.
The rules described above apply to non-variable annuity contracts as well as to variable annuity contracts purchased after October 20, 1979, and to contributions made after October 20, 1979, to variable annuities issued prior to this date. If the owner of a variable annuity contract acquired prior to October 21, 1979, including any contributions applied to such an annuity contract pursuant to a binding commitment entered into before that date, dies prior to the annuity starting date, the contract acquires a new “step-up” cost basis. The basis of the contract in the hands of the beneficiary will be the value of the contract at the date of the decedent’s death, or the alternate valuation date. If that basis equals the amount received by the beneficiary, there will be no income taxable gain and the appreciation in the value of the contract while owned by the decedent will escape income tax entirely. However, where a variable annuity contract purchased before October 21, 1979, had been exchanged for another variable annuity contract under IRC Section 1035 after October 20, 1979, and the annuity owner died prior to the annuity starting date, the beneficiary was not entitled to a step-up in basis. Although the aforementioned step-up in basis treatment for pre-October 21, 1979, annuities has only been directly ruled on in the case of a variable annuity, it also would theoretically apply to fixed annuities issued prior to October 21, 1979
Normally the death benefit is payable at death. If it is not payable until a later time and the annuitant also was the owner of the annuity contract, see Q 397.
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.IRC Sec. 72(e)(5)(E); Treas. Reg. §1.72-11(c).