An annuity is a complicated beast — and during tax season, your clients’ questions can pile up faster than hospitality complaints from the crowds at Sochi. How are payments under a variable immediate annuity taxed? When is the exchange of one annuity contract for another a nontaxable exchange? Read on to find answers to these and other queries.
1. What general rules govern the income taxation of payments received under annuity contracts?
The rules in IRC Section 72 govern the income taxation of all amounts received under nonqualified annuity contracts.(Nonqualified annuities are annuities that are not held within a “qualified” retirement plan or an IRA.) IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns. Qualified annuity contracts are governed by the tax rules of the retirement account in which they are held.
The term “annuity” includes all periodic payments resulting from the systematic liquidation of a principal sum and refers not only to payments for a life or lives, but also to installment payments that do not involve life contingency, such as payments under a “fixed period” or a “fixed amount” settlement option.
All “amounts received” under an annuity contract are either “amounts received as an annuity” or “amounts not received as an annuity.”
“Amounts received as an annuity” (annuity payments) are taxed under the annuity rules in IRC Section 72. These rules determine what portion of each payment is excludable from gross income as a return of the purchaser’s investment and what portion is taxed as interest earned on the investment. They apply to life income and other types of installment payments received under both immediate annuity contracts, and deferred annuity contracts that have been annuitized.
Payments consisting of interest only are not annuity payments and thus are not taxed as “amounts received as an annuity.” Periodic payments on a principal amount that will be returned intact on demand are interest payments. Such payments, and all amounts taxable under IRC Section 72 other than regular annuity payments, are classed as “amounts not received as an annuity.” These include amounts actually received as policy dividends, lump sum cash settlements of cash surrender values, cash withdrawals and amounts received on partial surrender, death benefits under annuity contracts, a guaranteed refund under a refund life annuity settlement, and policy loans, as well as amounts received by imputation (annuity cash value pledged as collateral for a loan).
Except in the case of certain annuity contracts held by non-natural persons, income credited on a deferred annuity contract is not currently includable in a taxpayer’s income. There is no specific IRC section granting this “tax deferral.” Instead, it is granted by implication. The increase in cash value of an annuity contract, other than by application of dividends, is neither an “amount received as an annuity” nor an “amount not received as an annuity.” As a result, an increase in cash value is not a distribution and is not includable in the taxpayer’s income, except where the IRC specifically provides otherwise.
IRC Section 72 places a penalty on “premature distributions.”
Contracts issued after January 18, 1985 have post-death distribution requirements. These post-death distribution requirements also apply to contributions made after January 18, 1985, to contracts that were issued before that date. Contracts issued before January 18, 1985, with contributions that were made before that date are not subject to post-death distribution requirements.
The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of life insurance death proceeds. However, the rules for taxing such payments are similar to the IRC Section 72 annuity rules. On the other hand, as noted earlier, death proceeds under an annuity contract (i.e., from some form of guaranteed death benefit) are taxed as amounts not received as an annuity.
Employee annuities, under both qualified and nonqualified plans, and periodic payments from qualified pension and profit sharing trusts are taxable under IRC Section 72, but because a number of special rules apply to these payments, they are treated separately.
Annuity with long-term care rider: Under the Pension Protection Act of 2006, qualified long term care insurance can be provided as a rider to an annuity contract, beginning after December 31, 2009.
2. How are annuity contracts held by corporations and other non-natural persons taxed?
Except as noted below, to the extent that contributions are made after February 28, 1986 to a deferred annuity contract held by a corporation or another entity that is not a natural person, the contract is not treated for tax purposes as an annuity contract.
When an annuity contract is no longer treated as an annuity for tax purposes, income on the contract is treated as ordinary income received or accrued by the owner during the taxable year. “Income on the contract” is the excess of (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (the amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement.
This rule does not apply to any annuity contract that is:
- acquired by the estate of a decedent by reason of the death of the decedent;
- held under a qualified pension, profit sharing, or stock bonus plan, as an IRC Section 403(b) tax sheltered annuity, or under an individual retirement plan;
- purchased by an employer upon the termination of a qualified pension, profit sharing, or stock bonus plan or tax sheltered annuity program and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or to the employee’s beneficiary;
- an immediate annuity (i.e., an annuity that is purchased with a single premium or annuity consideration, the annuity starting date of which is no later than one year from the date of purchase, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period); or
- a qualified funding asset (as defined in IRC Section 130(d) but without regard to whether there is a qualified assignment). A qualified funding asset is any annuity contract issued by a licensed insurance company that is purchased and held to fund periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness.
In addition, an annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person. If a non-natural person is the nominal owner of an annuity contract but the beneficial owner is a natural person, the annuity contract will be treated as though held by a natural person. Also, an annuity owned by a grantor trust will be considered to be owned by the grantor of the trust.
In a letter ruling, the IRS decided that a trust was considered to hold an annuity contract as an agent for a natural person where the trust owned an annuity contract which was to be distributed, prior to its annuity starting date, to the trust’s beneficiary, a natural person.
In another ruling, the IRS considered an irrevocable trust whose trustee purchased three single premium deferred annuities, naming the trust as owner and beneficiary of the contracts and a different trust beneficiary as the annuitant of each contract. The terms of the trust provided that the trustee would terminate the trust and distribute an annuity to each trust beneficiary after a certain period of time. The IRS held that the non-natural person rule was not applicable.
The IRS concluded that the non-natural person rule does not apply to a trust that had invested trust assets in a single premium deferred variable annuity where the same individual was the sole annuitant under the contract and the sole life beneficiary of the trust.
Where a trustee’s duties were limited to purchasing an annuity as directed by an individual and holding legal title to the annuity for that individual’s sole benefit and the trustee was not able to exercise any rights under the annuity contract unless directed to do so by the individual, the IRS concluded that the trustee was acting as an agent for a natural person.
Further, where the trustee of an irrevocable trust purchased an annuity and had the power to select an annuity settlement option or terminate the annuity contract, the annuity was still considered to be owned by a natural person.
A charitable remainder unitrust, however, was not considered to hold an annuity contract as an agent for a natural person and, thus, was required to include income on any annuity contracts in ordinary income each year.
Although it is not entirely clear that all permissible beneficiaries of a trust named as owner of a deferred annuity must be natural persons, it is significant that, as of June 2010, all private letter rulings addressing whether a trust named as owner of a deferred annuity was acting as “the agent of a natural person” have specified that all beneficiaries were, in fact, natural persons.
If all beneficiaries of a trust owning a deferred annuity must be natural persons, must the term “beneficiary” be taken literally? In the case of a “special needs” trust (such as an OBRA “D(4)(A)” trust), it is not clear whether the position of creditor occupied by the state Medicaid agency (to the extent of any Medicaid payments made to the trust beneficiary) will constitute the interest of a “beneficiary,” where the state Medicare statute does not specify that the state’s interest is that of a “beneficiary.”
These requirements apply “to contributions to annuity contracts after February 28, 1986.” It is clear that if all contributions to the contract are made after February 28, 1986, the requirements apply to the contract. It seems clear enough that if no contributions are made after February 28, 1986 to an annuity contract, such contract held by a non-natural person is treated for tax purposes as an annuity contract and is taxed under the annuity rules. If contributions have been made both before March 1, 1986, and after February 28, 1986, to contracts held by non-natural persons, however, it is not clear whether the income on the contract is allocated to different portions of the contract and whether the portion of the contract allocable to contributions before March 1, 1986, may continue to be treated as an annuity contract for income tax purposes. The IRC makes no specific provision for separate treatment of contributions to the same contract made before March 1, 1986, and those made after February 28, 1986.
3. How can the investment in the contract be determined for purposes of the annuity rules?
Generally speaking, the investment in the contract is the gross premium cost or other consideration paid for the contract, reduced by amounts previously received under the contract to the extent they were excludable from income.
Unless the contract has been purchased from a previous owner, the investment in the contract normally is premium cost. It is not equal to the policy’s cash value.
To arrive at the premium cost, adjustments usually must be made to gross premium cost.
Extra premiums paid for supplementary benefits such as accidental death benefit, disability income benefit, and disability waiver of premiums must be excluded from premium cost. (But see Moseley v. Comm., where life insurance policy premium payments paid into a special reserve account were added to the aggregate premiums for purposes of calculating taxable income when a lifetime distribution was made). Further, it might seem that premiums waived on account of disability should be treated as part of the premium cost. In the only case on the subject, however, a case dealing with the computation of gain on a matured endowment, the court held that waived premiums could not be included in the taxpayer’s cost basis. The court refused to accept the view of the taxpayer that the waived premiums had been constructively received as a tax-free disability benefit and then applied to the payment of premiums. Instead, the court treated a portion of the proceeds as the tax-free disability benefit: the difference between the amount of premiums actually paid and the face amount of the endowment.
Investment in the contract is increased by any amount of a policy loan that was includable in income as an amount received under the contract. Any un-repaid policy loans must be subtracted from gross premiums in determining the investment in the contract for purposes of the exclusion ratio.
If premiums were deposited in advance and discounted, only the amount actually paid is includable in premium cost. However, any increment in the advance premium deposit fund that has been reported as taxable income may be added to the discounted premiums in determining cost.
In the case of a participating contract, dividends must be taken into account as follows:
If dividends have been received in cash or used to reduce premiums, the aggregate amount of such dividends received or credited before the annuity payments commenced must be subtracted from gross premiums to the extent the dividends were excludable from gross income. Also, any dividends that have been applied against principal or interest on policy loans must be subtracted, but only to the extent they were excludable from gross income. (Excludable dividends are considered as a partial refund of premiums and therefore as a reduction in the cost of the contract).
If excludable dividends have been left on deposit with the insurance company to accumulate at interest and the dividends and interest are used to produce larger annuity payments, such dividends are not subtracted from gross premiums but are part of the cost of the larger payments. In this situation, gross premiums plus accumulated interest constitute the cost of the contract. (The interest is included as additional cost because it already has been taxed to the policyholder as it was credited from year to year). Likewise, any terminal dividend that is applied to increase the annuity payments should not be subtracted from gross premium cost.
Similarly, where dividends have been applied to purchase paid-up additional insurance, and the annuity payments include income from the paid-up additions, gross premiums are used as the cost of the contract. (In effect, the dividends constitute the cost of the income from the paid-up additions).
Cost Other than Premium Cost
Investment in the contract is not always equal to premium cost. For example, investment in the contract may be the maturity value or cash surrender value of the contract if such value has been constructively received by the policyholder. If the contract has been purchased from a previous owner, the investment in the contract is the consideration paid by the purchaser. Also, special rules apply in computing the investment in the contract with respect to employee annuities, that is, annuities on which an employer has paid all or part of the premiums.
Long-Term Care Rider Premiums
For contracts issued after 1996, but only for tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long-term care contract that is a rider to the annuity or life insurance contract reduces the investment in the contract of the annuity or life insurance contract. This charge against the cash surrender value, however, does not cause the taxpayer to recognize gross income. On the other hand, such charges are also not eligible for a medical expense deduction under Section 213(a).
Adjustment for Refund or Period-Certain Guarantee
If an annuity is a life annuity with a refund or period-certain guarantee, a special adjustment must be made to the investment in the contract (whether premium cost or other cost). The value of the refund or period-certain guarantee (as determined by use of a prescribed annuity table, Table III or Table VII, or a formula, depending on when the investment in the contract was made) must be subtracted from the investment in the contract. It is this adjusted investment in the contract that is used in the exclusion ratio.
4. What are the income tax consequences to the surviving annuitant under a joint and survivor annuity?
The survivor continues to exclude from gross income the same percentage of each payment that was excludable before the first annuitant’s death. With respect to annuities having a starting date after December 31, 1986, the total exclusion by the first annuitant and the survivor may not exceed the investment in the contract; that is, when the entire investment in the contract has been received tax-free, the entire amount of all subsequent payments will be taxed as ordinary income. However, for annuities with starting dates prior to January 1, 1987, the exclusion ratio continues to apply indefinitely to annuity payments, even if the amount of principal recovered exceeds the original investment in the contract.
In addition, if the value of the survivor annuity was subject to estate tax, the survivor may be entitled to an income-in-respect-of-a-decedent income tax deduction for a portion of the estate tax paid. This deduction, in most cases, will be small. Generally, it is computed as follows: The portion of the guaranteed annual payment that will be excluded from the survivor’s gross income (under the exclusion ratio) is multiplied by the survivor’s life expectancy at the date of the first annuitant’s death. The result is subtracted from the estate tax value of the survivor’s annuity. The total income tax deduction allowable is the estate tax attributable to this remainder of the value of the survivor’s annuity. This total deduction is prorated over the survivor’s life expectancy as of the date of the first annuitant’s death, and a prorated amount is deductible from the survivor’s gross income each year as payments are received. But no further deduction is allowable after the end of the survivor’s life expectancy. The foregoing treatment applies only where the primary annuitant died after 1953.
Planning Point: Joint ownership of non-qualified annuities creates more problems than it solves, including forced distribution at either owner’s death. Where the designated beneficiary of each owner is other than the other owner, payment, at either owner’s death, generally will be made to that beneficiary, effectively (and surprisingly) “disinheriting” the surviving owner. Some annuity contracts contain language stating that if the contract is jointly owned (with a right of survivorship), the surviving owner will be deemed to be the deceased owner’s primary beneficiary, notwithstanding any beneficiary designation to the contrary. Some insurers will not issue deferred annuities with joint ownership unless the owners are a married couple.
It is worth noting that joint ownership often is unnecessary to achieve the objective that the policy owners may believe requires such ownership. For example, if a husband owns, and is the annuitant of, a deferred annuity of which the wife is primary beneficiary, the death of either will leave the survivor in complete control of the contract. If the husband dies, the wife, as the surviving spouse and primary beneficiary, may receive the death benefit or treat the contract as her own under IRC §72(s)(3). If the wife dies first, the husband remains in full control of the contract. — John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.
5. If an annuitant dies before receiving the full amount guaranteed under a refund or period-certain life annuity, is the balance of the guaranteed amount taxable income to the refund beneficiary?
The beneficiary will have no taxable income until the total amount the beneficiary receives, when added to amounts that were received tax-free by the annuitant (i.e., the excludable portion of the annuity payments), exceeds the investment in the contract. In other words, all amounts received by the beneficiary under a refund guarantee are exempt from tax until the investment in the contract has been recovered tax-free. Thereafter, receipts (if any) are taxable income. For purposes of calculating the unrecovered investment in the contract, the value of the refund or guarantee feature is not subtracted. This “FIFO” treatment, for payments made to the beneficiary, is different from the “regular annuity rules” treatment that applied to payments made to the deceased annuitant.
The amount received by the beneficiary is considered paid in full discharge of the obligation under the contract in the nature of a refund of consideration and therefore comes under the cost recovery rule regardless of when the contract was entered into or when investments were made in the contract. This rule applies whether the refund is received in one sum or in installments made under the same payout arrangement under which the deceased annuitant had been receiving payments.
If the refund or commuted value of remaining installments certain is applied anew under a different annuity option for the beneficiary, the payments will be taxed under the regular annuity rules. A new exclusion ratio will be determined for the beneficiary.