Q: What are the income tax results when an annuitant makes a partial lump sum withdrawal and takes a reduced annuity for the same term or the same payments for a different term?


A: The income tax results in these scenarios are different depending on the annuitant’s circumstances. 

Reduced annuity for same term

The nontaxable portion of the lump sum withdrawn is an amount that bears the same ratio to the unrecovered investment in the contract as the reduction in the annuity payment bears to the original payment. The original exclusion ratio will apply to the reduced payments; that is, the same percentage of each payment will be excludable from gross income.[1]

Example. Mr. Gray pays $20,000 for a life annuity paying him $100 a month. At the annuity starting date his life expectancy is twenty years. His total expected return is therefore $24,000 (20 × $1,200), and the exclusion ratio for the payment is five-sixths ($20,000/$24,000). He receives annuity payments for five years (a total of $6,000) and excludes a total of $5,000 ($1,000 a year) from gross income. At the beginning of the next year, Mr. Gray agrees with the insurer to take a reduced annuity of $75 a month and a lump sum cash payment of $4,000. He will continue to exclude five-sixths of each annuity payment from gross income; that is, $62.50 (5/6 of $75). Of the lump sum, he will include $250 in gross income and exclude $3,750, determined as follows:

 

Investment in the contract

$20,000

Less amounts previously excluded

5,000

Unrecovered investment

$15,000

Ratio of reduction in payment to original payment ($25/$100)

1/4

Lump sum received

$ 4,000

Less 1/4 of unrecovered investment (1/4 of $15,000)

3,750

Portion of lump sum taxable

$ 250

   

 

Same payments for different term

If an annuity contract was purchased before August 14, 1982 (and no additional investment was made after August 13, 1982, in the contract), the lump sum withdrawn is excludable from gross income as “an amount not received as an annuity” that is received before the annuity starting date. Thus, the lump sum is subtracted from the unrecovered premium cost, and the balance is used as the investment in the contract. A new exclusion ratio must be computed for the annuity payments.[2]

If the lump sum withdrawn is allocable to investment in an annuity contract made after August 13, 1982, it would appear that there will be a taxable withdrawal of interest if the cash surrender value of the contract exceeds investment in the contract (Q 355, Q 356) and a new exclusion ratio must be computed, using an investment in the contract reduced by any amount of the lump sum excludable as a return of investment.

 

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[1]

.Treas. Reg. §1.72-11(f).

[2]

.Treas. Reg. §1.72-11(e).

 

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.