Due to old and unmodified IRS life expectancy tables, particularly Table V and VIII, many immediate annuities (mortality polled income contracts) may produce income tax advantages in the form of a “non-taxable” income source. Of course, non-taxable income is not the same as tax free income.
How is this possible? It’s possible because these old IRS tables still assume shorter life expectancies derived from 1970s and earlier data. The shorter the assumed life expectancy for IRS tax issues the greater the premium cost recovery rate as a percentage of the annual annuity income.
When these old IRS tables are combined with the current annuity industry practice of assuming modern life expectancies and the ultra-low interest rate environment, the actual annuity annual income can be completely non-taxable depending on the immediate annuity variability selected.
Just because these contracts may initially produce 100 percent non-taxable income doesn’t mean they are not earning any interest. You always earn interest with a fixed annuity but, you just may not have to pay income tax on it right away depending on the contract. Again, we are talking about mortality pooled annuities and not deferred cash value annuities with guaranteed lifetime withdrawal benefit (GLWB) features.
Let’s look at a few examples of how this works utilizing an easy to understand annuity and easy to calculate cost basis recovery rate. One of the easiest immediate contracts to understand, not necessarily the most popular, is the “life-only” annuity contract. Simply put, this contract pays an annual income for the lifetime of an individual then, terminates upon his or her death. In this case, the IRS uses Table V (without respect to gender) to calculate the annual annuity premium cost recovery permitted.
For a life-only annuity, a person age 76 gets 11.90 years or 142.80 months to calculate the annual premium cost recovery permitted for income tax purposes. If the premium cost basis is $100,000, this amounts to a monthly premium cost recovery rate of $700. However, if the actual monthly annuity payment from the company is only $695, guess what?