Immediate annuities, known to be rich in guaranteed income, are also rich in multigenerational income tax benefits versus other annuities. One of my all-time favorite immediate annuity income tax strategies, for both contract owners and their beneficiaries for wealth transfer purposes, is the interplay of IRS permitted cost basis recovery rules between the generations. More proof of why they are my favorite: the Federal government really likes these contracts and lavishes tax benefits accordingly.
Let’s look at the following typical annuity case for a father, age 80, who has a primary need to pass a tax advantage estate to his highly-compensated adult child, age 55, with the father’s income need secondary. To help insure an annuity estate benefit, dad purchased a 30-year period certain (360 months) and lifetime thereafter annuity with a monthly benefit of $423 with a non-taxable portion of $281 for a $100,000 premium cost. As expected, dad dies at age 85 when son is age 60. Son stands ready to collect on the 25-years of remaining period certain payments.
How will the son pay income tax on these payments? In this case, the tax rule is: at dad’s death, the beneficiary son doesn’t pay income tax on these annuity payments, even though the dad was paying income tax on the annual taxable income — in this case $1,704 ([$423 – $281] x 12). The son, upon inheriting this income, receives a tax benefit.
The tax benefit to the son is first-in, first-out (FIFO) cost basis recovery treatment. In this example, since the initial cost basis was $100,000 and dad received $16,860 ($281 x 60) of cost basis, by the time of his death at age 85 there was a remaining cost basis of $83,140 ($100,000 – $16,860) available to the son now age 60.
Since the son gets FIFO income tax treatment, the monthly income of $423 is non-taxable because the entire cost basis has to be recovered first. This tax benefit lasts for the next 196.55 months ($83,140/$423) or 16.40 years. In this example, the son will not start to pay income tax on his $423 monthly annuity inheritance until age 76 and 4 months. This is well past his own retirement age, when it is assumed he will be in a lower tax bracket than now at age 60 and still working. Monthly taxable income will not pick up again until after age 76 and 4 months when it becomes 100 percent taxable and payable to age 85 when the last payment is made.
After the dad’s death, if the son doesn’t survive to collect all the remaining payments, the son gets to name his own beneficiary who will collect the payment balance in the same tax efficient manner. In these beneficiary cases, the internal deferral of all the contract gain falls to the end of the remaining period certain duration.
Just remember that when it comes to tax benefits and who gets what benefit, not all annuities are created equal. Immediate annuities have a lot more going for them than just the mere income they produce. That’s the idea: “always keep your hands up.”