As part of ThinkAdvisor’s Special Report, 22 Days of Tax Planning Advice: 2015, throughout the month of March, we are partnering with our ALM Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
This is part 2 of a two-part look at six important tax questions, covering questions 4-6, about Deferred Annuities; check out Part 1.
4. Is the full gain on a deferred annuity or retirement income contract taxable in the year the contract matures?
If the contract provides for automatic settlement under an annuity option, the lump sum proceeds are not constructively received in the year of maturity; if the policy provides a choice of settlement options, the policy owner can opt out of the lump sum proceeds choice within 60 days and avoid constructive receipt. The annuity payments (whether life income or installment) are taxed under the regular annuity rule as they are received in the future. In computing the exclusion ratio for the payments, the amount to be used as the investment in the contract is premium cost, not the maturity value.
Of course, if the contract owner takes a lump sum settlement at maturity, the contract owner must include the gain in gross income for the year in which he or she receives the payment.
5. 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?
Yes, to the extent there are any gains.
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 premiums paid or the accumulated value of the contract (although some contracts may provide additional “enhanced” death benefits as well).
The gain, if any, is taxable as ordinary income to the beneficiary, and is measured by subtracting (1) investment in the contract (reduced by aggregate dividends and any other amounts that have been received under the contract that were excludable from gross income) from (2) the death benefit, including any enhancements. The gains are taxable when received, and are taxable to the beneficiary that receives the payments (not the decedent). Thus, annuities do not receive a step-up in basis at death (except for certain pre-October 21 1979 grandfathered annuities).
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. Instead, death benefits paid on the death of the owner or 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 any Federal estate taxes paid that were 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.
In the case of a deferred annuity that provides the beneficiary with the option to take the death benefit as a lump sum, the beneficiary 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. The periodic payments then will be taxable to the beneficiary under the regular annuity rules. The exclusion ratio for the contract will be based on the decedent’s investment in the contract and the beneficiary’s expected return.