If your clients are like most, come tax time they’ll have a number of questions for you, their trusty financial advisor. What penalties apply to premature distributions? What if I made a partial lump sum withdrawal last year, and am now taking a reduced annuity? Without further ado, here are the answers to eight questions annuity holders frequently ask.
Q: How are annuity payments taxed?
A: The basic rule for taxing annuity payments (i.e., “amounts received as an annuity”) is designed to return the purchaser’s investment in equal tax-free amounts over the payment period and to tax the balance of each payment received as earnings. Each payment, therefore, is part nontaxable return of cost and part taxable income. Any excess interest (dividends) added to the guaranteed payments is reportable as income for the year received.
Q: Are dividends payable on an annuity contract taxable income?
A: Taxation of dividends under an annuity contract depends on when the contract was purchased. If the contract was purchased after August 13, 1982, dividends received before the annuity starting date are taxable to the extent the cash value of the contract (determined without regard to any surrender charge) immediately before the dividend is received exceeds the investment in the contract at the same time. If there is no excess of cash value over the investment in the contract (i.e., no gain), further dividends are treated as a tax-free recovery of investment. If the annuity contract was purchased before August 14, 1982, and no additional investment was made in the contract after August 13, 1982, the dividends will be taxed like dividends received under life insurance contracts (generally tax-free until basis has been recovered).
. IRC Sec. 72(e).
Q: What penalties apply to “premature” distributions under annuity contracts?
A: To discourage the use of annuity contracts as short term tax sheltered investments, a 10 percent tax is imposed on certain “premature” payments under annuity contracts. The penalty tax applies to any payment received to the extent the payment is includable in income. There are nine exceptions to the penalty tax.
.IRC Sec. 72(q).
Q: What is the tax treatment of dividends where annuity values are paid in installments or as a life income?
A: Dividends received before the annuity start date or the first date that an amount is received as an annuity, whichever is later, are included in the recipient’s gross income to the extent that those dividends, taken with other amounts received under the contract that were excludable from gross income, are greater than the total premiums (or other consideration) paid by the recipient to that date. Also, dividends thus received must be subtracted from the consideration paid for purposes of the exclusion ratio that will be applied to payments received from the annuity after the date of the dividend.
. Treas. Reg. §1.72-11(b)(1).
Q: What tax rules govern dividends, cash withdrawals, and other amounts received under annuity contracts before the annuity starting date?
A: Policy dividends (unless retained by the insurer as premiums or other consideration), cash withdrawals, amounts received as loans and the value of any part of an annuity contract pledged or assigned, and amounts received on partial surrender under annuity contracts entered into after August 13, 1982, are taxable as income to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract (i.e., to the extent there is gain in the contract). To the extent the amount received is greater than the gain, the excess is treated as a tax-free return of investment. In effect, this ordering treatment results in distributions being treated as interest or gains first and only second as recovery of cost. (In addition, taxable amounts may be subject to a 10 percent penalty tax unless paid after age 59½ or disability.)
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 are different depending on the annuitant’s circumstances. When taking a reduced annuity for the 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.
.Treas. Reg. §1.72-11(f).
Q: How is the excludable portion of an annuity payment under a fixed period or fixed amount option computed?
A: For non-variable contracts, the basic annuity rule applies: Divide the investment in the contract by the expected return under the contract to determine the exclusion ratio for the payments. Apply this ratio to each payment to find the portion that is excludable from gross income. The balance of the payment is includable in gross income.
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?
A: Yes. 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.
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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.