Social Security worries are increasing, Medicare myths are multiplying and creative ways to help our clients navigate through their retirement and end-of-life years can be difficult if not challenging for advisors and our clients’ families.
In previous articles we have discussed the senior market, dominant buying motives, reasons seniors buy and what the right annuity can do for the right client.
In this series of articles we are going to look at some examples demonstrating the difference between annuitant-driven contracts and owner-driven annuity contracts. This series is not meant to address a particular carrier or a specific product but rather the idea of how the contract may need to be written and why.
An annuitant-driven contract terminates upon the death of the annuitant while an owner-driven contract terminates upon the death of the owner. (All examples in this series are for non-qualified annuities.)
All deferred annuities provide the holder with the option to purchase an income annuity for the life of the annuitant at permanently guaranteed purchase rates.
Note: Federal income tax law requires that the remaining interest under the non-qualified contract be paid out in a certain manner (except where the designated beneficiary is the owner’s surviving spouse) upon the owner’s death (IRC section 72(s) ).
If the owner and the annuitant are the same person, then contractual benefits should be paid whether the contract is an owner-driven or an annuitant-driven since the owner and the annuitant will have died.
Your male, 62-year old client purchased two non-qualified annuity contracts in 2004 from a life insurance company. His initial investment in each contract was $65,000 and each contract has an accumulated value of $120,000 (no surrender charges).
Are there any tax consequences of a $70,000 withdrawal from one of these contracts?
Non-qualified contracts issued by the same insurer (or by an affiliated insurer) to the same policyholder during the calendar year must be aggregated and will be treated as one contract for tax purposes. Therefore, the combined accumulated value of the two contracts is $240,000 and the basis is $130,000. Since the total gain in the combined contracts is $110,000, the entire $70,000 withdrawal will be taxable.
Pledges and loans
Your male, 54-year-old client owns a non-qualified annuity contract with an accumulated value of $225,000, a surrender value of $200,000, and a basis of $100,000. His local bank is lending money to him provided he pledges his annuity contract as collateral for the loan.
Are there any general income tax consequences of such a pledge?
A pledge of an annuity contract is considered a deemed distribution and the amount pledged will be treated as an amount not received as an annuity (IRC 72(e)(4)(A) ). The amount pledged will be treated as a withdrawal and your client will be taxed on the difference between the accumulated value and the investment in the contract ($225,000 – $100,000 = $125,000 of taxable ordinary income).
Taxation of withdrawals
You have a 60-year-old female client who purchased a non-qualified annuity contract in 2005 with an initial payment of $125,000. The contract now has an accumulated value of $195,000 and a surrender value of $191,000.
What are the tax consequences if your client takes a withdrawal of $95,000? What are the tax consequences if your client surrenders the annuity contract?
When determining the taxable portion of an annuity withdrawal, the investment from the contract is subtracted from the accumulated value to determine the amount of the gain. Distributions of gain are made first, and after all gain has been distributed the investment in the contract is distributed. In this example the difference between the accumulated value and the investment in the contract is $70,000. Consequently, a distribution of $95,000 will result in $70,000 of ordinary income and $25,000 represents a return of the investment in the contract.
When a contract is surrendered, the taxable amount is determined by subtracting the investment from the contract from the surrender value. Your client would realize $66,000 of ordinary income if she surrendered the contract.
In 2003 when your client was 40 years old he purchased an annuitant-driven annuity contract and designated himself as the owner, his mother as the annuitant, and his younger brother as the beneficiary. The contract was purchased with a single payment of $50,000 and now has an accumulated value of $105,000 (no surrender charges) when his mother dies suddenly at the age of 60.
What, if any, are the tax consequences upon the death of your client’s mother?
Taxable distributions from an annuity contract are subject to an additional 10 percent penalty tax unless the distribution meets one of the exceptions contained in IRC section 72(q)(2) dealing with non-qualified annuities. One such exception to the 10 percent penalty is for a distribution on account of the death of the owner (holder). The contract in this example is an annuitant-driven contract that terminated upon the death of the annuitant – not the owner. Therefore, the premature distribution exception does not appear to apply. The $55,000 gain would be currently subject to ordinary income tax (assuming that the amounts are distributed upon the death) and subject to the 10 percent penalty tax since the owner is under 59-and-a-half.
Premature distributions – Exceptions
- Age 59-and-a-half
- Death of Owner
- Immediate Annuity
- Substantially Equal Periodic Payments
- Effective Date
The exception for disability is very limited since the definition under 72(m)(7) requires the individual to be unable to engage in any substantial gainful activity or any medically determinable physical or mental impairment that can be expected to result in death or to be of a long-continued and indefinite duration. Proof of disability must be furnished.
An immediate annuity is an annuity purchased with a single premium or annuity consideration, and the annuity date commences no later than one year from the date of purchase. In addition, the annuity contract must provide for substantially equal periodic payments, payable at least annually during the annuity period.
Substantially equal periodic payments (SEPP): The annuitization method, the amortization method, and the required minimum distribution method are the three types of payments that will be considered SEPP. The first two generally provide level amounts and will usually provide the largest payout. Payments under the RMD method will fluctuate from year to year and will generally provide the smallest payment. The additional 10 percent penalty tax applies to premature distributions from contracts issued after January 18, 1985.
Premature Distributions – Special Rule
Contracts issued after August 13, 1982 and prior to January 18, 1985 may not be subject to the penalty tax provided the distribution is allocable to an investment in the contract more than 10 years before the date of distribution.
Death of Owner – Spousal Continuation
Your married couple clients would like to jointly own an annuity contract so the survivor could continue the contract upon the death of the first spouse. Upon the death of the survivor, they want the contract to pass to their granddaughter.
How can you title the contract to meet their goals?
It is not necessary for a contract to be jointly owned by a husband and wife to provide for spousal continuation. Generally, having the contract jointly owned will not assure spousal continuation unless the beneficiary is the surviving spouse of the deceased owner. The contract could be titled as Mr. and Mrs. [name here] owners and the beneficiary could be designated as the surviving spouse, if permitted under terms of the contract.
Your 68-year-old client purchased an annuity contract in 1981 with an initial payment of $25,000. He completed a 1035 exchange in 1988, 1998 and in 2003. He never made any additional payments and the contract has an account value (no surrender charges) of $140,000. Your client decides to withdraw $40,000 for a lifestyle purchase (home remodel, purchase a car, etc.).
Are there any tax implications of the withdrawal? What if he has received $40,000 in cash as part of a 1035 exchange and rolled over the remaining $100,000?
Distributions from contracts issued prior to August 14, 1982 (pre-TEFRA) are taxed on a FIFO basis meaning basis is distributed before income. This only applies to investments (basis) in the contract before this date. These contracts were grandfathered and this benefit was extended to a grandfathered contract that was subsequently exchanged. Therefore, in the example above, the pre-TEFRA contribution of $25,000 is withdrawn first and is not taxed and the remaining part of the withdrawal ($15,000) will be taxable.
When property in addition to the exchanged-for property is received as part of a 1035 exchange, the additional property received will be taxable to the extent of the gain in the contract not to exceed the amount received. In this example, $40,000 in cash is received in addition to the new annuity contract. There is a $115,000 gain in the contract being exchanged so the entire $40,000 received in cash will be taxable. The remaining gain will not be taxed until there is a distribution and the basis in the old contract is carried over to the new contract.
- Partial exchanges
- Exchanges to an existing contract
- 1035 Exchange requirements: Life to life, endowment or an annuity contract
- Endowment to another endowment or annuity contract
- Annuity to annuity contract
- The owner and the insured/annuitant should be the same on both the old and the new contract.
The Internal Revenue Service has issued a Revenue Ruling in which it stated that it is possible to execute a 1035 exchange to an existing annuity contract. Not all insurance companies may allow this so it is important to first check with the companies involved before initiating this type of exchange.
Taxation of annuity payments
Each payment is generally comprised of two components:
- Return of basis
- Ordinary income
How are these amounts determined?
Taxation of Annuity Payments – Exclusion Ratio
Fixed Annuity Payments
Exclusion Ratio = Investment ÷ Expected Return
Variable Annuity Payments
Excludable amount determined by dividing investment in the contract by the number of years it is anticipated the annuity will be paid.
Estate tax issues
Income in respect of a decedent.
When an owner of an annuity contract dies, the value of the contract will be included in the owner’s estate for estate tax purposes. The account value adjusted for any enhanced death benefits will represent the value of the annuity contract when the owner dies prior to the annuity starting date. If the contract has been annuitized, then the present value of the remaining payments will be included in the decedent’s estate (the replacement cost of the commercial annuity). This means the value of the annuity included in the estate is subject to estate tax and the payments received by the beneficiary may also be subject to income taxes. The IRS has determined that payments from an annuity contract are considered income in respect of a decedent and may provide the beneficiary with a deduction that may help offset the estate taxes attributable to the inclusion of the annuity in the deceased’s estate.