The tax landscape for annuity products is a challenge to navigate, even for experts. What penalties apply to premature distributions? What are the tax consequences if a client wishes to annuitize only a portion of an annuity contract? How is an annuity owned by a grantor trust taxed? And what about QLACs?

Prepare for your clients’ questions — or simply test your knowledge — by reviewing this collection of 12 annuity tax facts. If you have unanswered questions on the taxation of annuities, let us know in the comments section below.

1. If an annuity is held by a trust or other entity as agent for a natural person, does the general rule that annuities held by non-natural persons are not taxed as annuities apply?

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 Private Letter Ruling (PLR) 9204014, 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.

See also: 6 trusts you should know about

In PLR 199905015, 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. 

Additionally, in PLR 972035 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. 

PLR 9639057 set forth the rule that 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 in PLR 199933033.

However, in PLR 9009047 a charitable remainder unitrust 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.”

2. What penalties apply to “premature” distributions under annuity contracts?

To discourage the use of annuity contracts as short term tax sheltered investments, a 10 percent tax is imposed on certain “premature” payments under annuity contracts. The penalty tax potentially applies to any payment received to the extent the payment is includable in income. Exceptions to the penalty tax include: 

(1) any payment made on or after the date on which the taxpayer becomes age 59½; 

(2) any payment made on or after the death of the holder (or the primary annuitant in the case where the holder is a non-natural person);

(3) any payment attributable to the taxpayer’s becoming disabled;

(4) any payment made under an immediate annuity contract;

(5) any payment that is part of a series of substantially equal periodic payments (SEPPs) made (not less frequently than annually) for the life or life expectancy of the taxpayer or the joint lives or joint life expectancies of the taxpayer and his or her designated beneficiary; 

(6) any payment made from a qualified pension, profit sharing, or stock bonus plan, under a contract purchased by such a plan, under an IRC Section 403(b) tax sheltered annuity, from an individual retirement account or annuity, or from a contract provided to life insurance company employees under certain retirement plans (but such payments are subject to similar premature distribution limitations and penalties; IRA; pension, profit sharing, stock bonus; tax sheltered annuity);

(7) any payment allocable to investment in the contract before August 14, 1982, including earnings on a pre-August 14, 1982 investment;

(8) any payment made from an annuity purchased by an employer upon the termination of a qualified plan and held by the employer until the employee’s separation from service; or 

(9) any payment under a qualified funding asset (i.e., any annuity contract issued by a licensed insurance company that is purchased as a result of a liability to make periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness).

Planning Point: SEPPs. From a practical standpoint, it would appear imprudent for an individual younger than age 45 to attempt to qualify for the exception for substantially equal periodic payments. A period longer than fifteen years may afford too much time in which a “material change” could occur. Also, the taxpayer might forget the importance of continuing to satisfy the conditions for this exception to the penalty tax. — Fred Burkey, CLU, APA, The Union Central Life Insurance Company.

Where a deferred annuity contract was exchanged for an immediate annuity contract, the purchase date of the new contract for purposes of the 10 percent penalty tax was considered to be the date upon which the deferred annuity was purchased. Thus, even if the new contract had been immediately annuitized, payments from the replacement contract did not fall within the immediate annuity exception to the penalty tax.

Also, if an annuity contract was issued between August 13, 1982 and January 19, 1985, a distribution of income allocable to any investment made ten or more years before the distribution is not subject to the penalty. For this purpose, amounts includable in income are allocated to the earliest investment in the contract to which amounts were not previously fully allocated. To facilitate accounting, investments are considered made on January 1 of the year in which they are invested. 

There also is a 10 percent penalty tax on certain premature distributions from life insurance policies classified as modified endowment contracts. 

The tax on premature distributions is not taken into consideration for purposes of determining the nonrefundable personal credits, general business credit, or foreign tax credit.

3. What are the tax consequences if a taxpayer wishes to annuitize only a portion of an annuity contract? 

Previously, the owner of an annuity or life insurance contract who wanted to annuitize a portion of a contract was required to split a contract into two and annuitize one of the resulting contracts. Splitting the contract was treated as a partial withdrawal and the owner was taxed prior to annuitization. As of 2011, that cumbersome two-step process is no longer necessary.

This result is due to the passage of the Small Business Jobs and Credit Act of 2010, (H.R. 5297). Section 2113 of the law amended IRC Section 72(a) to permit partial annuitization of annuity, endowment, and life insurance contracts — leaving the balance unannuitized — as long as the annuitization period is for ten years or more or is for the lives of one or more individuals.

When a contract is partially annuitized: (1) each annuitized portion of the contract is treated as a separate contract; (2) for purposes of calculating the taxable portion of annuity payments from a partially annuitized contract, investment in the contract is allocated pro rata between each portion of the contract from which amounts are received as an annuity and the portion of the contract from which amounts are not received as an annuity; and (3) each separately annuitized portion of the contract will have a separate annuity start date. 

Partial annuitization is permissible for tax years beginning after December 31, 2010. 

4. How is expected return on a non-variable annuity computed under the annuity rules?

Generally speaking, expected return is the total amount that the annuitant or annuitants can expect to receive over the annuitization period of the contract.

If payments are for a fixed period or a fixed amount with no life expectancy involved, expected return is the sum of the guaranteed payments. 

If payments are to continue for a life or lives, expected return is derived by multiplying the sum of one year’s annuity payments by the life expectancy of the measuring life or lives. The life expectancy multiple or multiples must be taken from the Annuity Tables prescribed by the IRS. (See here for IRS Annuity Tables).

Generally, gender-based Tables I – IV are to be used if the investment in the contract does not include a post-June 30, 1986 investment. Unisex Tables V – VIII are to be used if the investment in the contract includes a post-June 30, 1986 investment. Transitional rules permit an irrevocable election to use the unisex tables even where there is no post-June 1986 investment and, if investment in the contract includes both a pre-July 1986 investment and a post-June 1986 investment, an election may be made in some situations to make separate computations with respect to each portion of the aggregate investment in the contract using, with respect to each portion, the tables applicable to it. 

The life expectancy for a single life is found in Table I or in Table V, whichever is applicable. The life expectancy multiples for joint and survivor annuities are taken from Tables II and IIA or Tables VI and VIA, whichever are applicable.

The Annuity Tables are entered with the age of the measuring life as of his or her birthday nearest the annuity starting date. The multiples in the Annuity Tables are based on monthly payments. Consequently, where the annuity payments are to be received quarterly, semi-annually, or annually, the multiples from Tables I, II, and IIA or, as applicable, Tables V, VI, and VIA, must be adjusted. This adjustment is made by use of the Frequency of Payment Adjustment Table. No adjustment is required if the payments are monthly.

5. How is the excludable portion of payments under a single life annuity computed?

The following steps are taken in applying the basic annuity rule in order to determine the portion of payments that may be excludable from income in the case of a straight life annuity: 

(1) Determine the investment in the contract.

(2) Find the life expectancy multiple in Table I or V, whichever is applicable for a person of annuitant’s age (and sex, if applicable). Multiply the sum of one year’s guaranteed annuity payments by the applicable Table I or Table V multiple. For non-variable contracts, this is the expected return under the contract. For variable contracts, the “expected return” is the investment in the contract divided by the number of years over which payments will persist. 

(3) Divide the investment in the contract by the expected return under the contract, carrying the quotient to three decimal places. This is the exclusion ratio expressed as a percentage (“exclusion percentage”). 

(4) Apply the exclusion percentage to the annuity payment. The result is the portion of the payment that is excludable from gross income. The balance of the payment must be included in gross income. If the annuity starting date is after December 31, 1986, the exclusion percentage applies to payments received only until the investment in the contract is recovered. However, if the annuity starting date was before January 1, 1987, the same exclusion percentage applies to all payments received throughout the annuitant’s lifetime. 

Example 1: On October 1, 2015, Mr. Brown purchased an immediate non-refund annuity that will pay him $125 a month ($1,500 a year) for life, beginning November 1, 2015. He paid $16,000 for the contract. Mr. Brown’s age on his birthday nearest the annuity starting date (October 1) was 68. According to Table V (which he uses because his investment in the contract is post-June 1986), his life expectancy is 17.6 years. Consequently, the expected return under the contract is $26,400 (12 × $125 × 17.6). The exclusion percentage for the annuity payments is 60.6 percent ($16,000 ÷ $26,400). Because Mr. Brown received two monthly payments in 2015 (a total of $250), he will exclude $151.50 (60.6 percent of $250) from his gross income for 2015, and he must include $98.50 ($250 – $151.50). Mr. Brown will exclude the amounts so determined for 17.6 years. In 2015, he could exclude $151.50; each year thereafter through 2031, he could exclude $909, for a total exclusion of $15,604.50 ($151.50 excluded in 2015 and $15,453 excluded over the next 17 years). In 2032, he could exclude only $395.50 ($16,000 – $15,604.50), which is all the investment in the contract he has left. In 2032, he would include in his income $1,104.50 ($1,500 – $395.50). In 2033 and each year thereafter, all cost basis has been recovered, and he would include $1,500 in income each year. 

Example 2: If Mr. Brown purchased the contract illustrated above on October 1, 1986 (so that it had an annuity starting date before January 1, 1987), he would exclude $151.50 (60.6 percent of $250) from his 1986 gross income and would include $98.50 ($250 – $151.50). For each succeeding tax year in which he receives twelve monthly payments (even if he outlives his life expectancy of 17.6 years), he will exclude $909 (60.6 percent of $1,500), and he will include $591 ($1,500 – $909), even after 17.6 years’ worth of payments have been made.

To calculate the excludable portion for an annuity contract with a refund or period-certain guarantee, see here

6. How is the excludable portion of payments under an annuity with a single life refund or period-certain guarantee calculated?

The computations outlined in examples 1 and 2 in No. 6 above are for a straight life annuity (without a refund or period-certain guarantee). The exclusion ratio for a single life refund or period-certain guarantee is determined in the same way, but the investment in the contract first must be adjusted by subtracting the value of the refund or period-certain guarantee. The value of the refund or period-certain guarantee is computed by the following steps:

(1) Determine the duration of the guaranteed amount (number of years necessary for the total guaranteed return to be fully paid). In the case of a period-certain life annuity, the duration of the guaranteed amount, in years, is known (e.g., ten, fifteen, or twenty “years certain”). To find the duration of the guaranteed amount, in years, for a cash or installment refund life annuity, divide the total guaranteed amount by the amount of one year’s annuity payments, and round the quotient to the nearest whole number of years. 

(2) Find the factor in Table III or VII (whichever is applicable, depending on when the investment is made in the contract) under the whole number of years (as determined above) and the age and (if applicable) the sex of the annuitant. This Table III or Table VII factor is the percentage value of the refund or period-certain guarantee.

(3) Apply the applicable Table III or Table VII percentage to the smaller of (a) the investment in the contract, or (b) the total guaranteed return under the contract. The result is the present value of the refund or period-certain guarantee.

(4) Subtract the present value of the refund or period-certain guarantee from the investment in the contract. The remainder is the adjusted investment in the contract to be used in the exclusion ratio. 

Example 3: On January 1, 2015, a husband, age sixty-five, purchases for $21,053 an immediate installment refund annuity that pays $100 a month for life. The contract provides that in the event the husband does not live long enough to recover the full purchase price, payments will be made to his wife until the total payments under the contract equal the purchase price. The investment in the contract is adjusted for the purpose of determining the exclusion ratio as follows:

Unadjusted investment in the contract

$21,053

Amount to be received annually

$1,200

Duration of guaranteed amount ($21,053 ÷ $1,200)

17.5 yrs.

Rounded to nearest whole number of years

18

Percentage value of guaranteed refund (Table VII for age 65 and 18 years)

15%

Value of refund feature rounded to nearest dollar (15% of $21,053)

$3,158

Adjusted investment in the contract ($21,053 – $3,158)

$17,895

   

Example 4: Assume the contract in Example 3 was purchased as a deferred annuity, the pre-July 1986 investment in the contract is $10,000, and the post-June 1986 investment in the contract is $11,053. If the annuitant elects (as explained here) to compute a separate exclusion percentage for the pre-July 1986 and the post-June 1986 amounts, separate computations must be performed to determine the adjusted investment in the contract. The pre-July 1986 investment in the contract and the post-June 1986 investment in the contract are adjusted for the purpose of determining the exclusion ratios in the following manner: 

Pre-July 1986 adjustment:

 

Unadjusted investment in the contract

$10,000

 

Allocable part of amount to be received annually (($10,000 ÷ $21,053 x $1,200)

$570

 

Duration of guaranteed amount ($10,000 ÷ $570)

17.5 yrs.

 

Rounded to nearest whole number of years

18

 

Percentage in Table III for age 65 and 18 years

30%

 

Present value of refund feature rounded to nearest dollar (30% of $10,000)

$3,000

 

Adjusted pre-July 1986 investment in the contract ($10,000 – $3,000)

$7,000

Post-June 1986 adjustment:

 

Unadjusted investment in the contract

$11,053

 

Allocable part of amount to be received annually (($11,053 ÷ $21,053) x $1,200)

 $630

 

Duration of guaranteed amount ($11,053 ÷ $630)

17.5 yrs.

 

Rounded to nearest whole number of years

18

 

Percentage in Table VII for age 65 and 18 years

15%

 

Present value of refund feature rounded to nearest dollar (15% of $11,053)

$1,658

 

Adjusted post-June 1986 investment in the contract ($11,053 – $1,658)

$9,395

     

Once the investment in the contract has been adjusted by subtracting the value of the refund or period-certain guarantee, an exclusion ratio is determined in the same way as for a straight life annuity. The expected return is computed, then the adjusted investment in the contract is divided by expected return. Taking the two examples above, the exclusion ratio for each contract is determined as follows.

Example (3) above

Investment in the contract (adjusted for refund guarantee)

$17,895

One year’s guaranteed annuity payments (12 x $100)

$1,200

Life expectancy from Table V, age 65

20 yrs.

Expected return (20 x $1,200)

$24,000

Exclusion ratio ($17,895 ÷ $24,000)

74.6%

Amount excludable from gross income each year in which 12 payments are received (74.6% of $1,200)*

 $895.20

Amount includable in gross income ($1,200 – $895.20)*

$304.80

   

*Since the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract; after that has been recovered, the remaining amounts received are includable in income. However, if the annuity has a refund or guarantee feature, the value of the refund or guarantee feature is not subtracted when calculating the unrecovered investment.

Example (4) above

Pre-July 1986 investment in the contract (adjusted for period certain guarantee)

 $7,000

One year’s guaranteed annuity payments (12 x $100)

$1,200

Life expectancy from Table I, male age 65

15 yrs.

Expected return (15 x $1,200)

$18,000

Exclusion ratio ($7,000 ÷ $18,000)

38.9%

 

Post-June 1986 investment in the contract (adjusted for period certain guarantee)

 $9,395

One year’s guaranteed annuity payments (12 x $100)

$1,200

Life expectancy from Table V, age 65

20 yrs.

Expected return (20 x $1,200)

$24,000

Exclusion ratio ($9,395 ÷ $24,000)

39.1%

Sum of pre-July and post-June 1986 ratios

78%

Amount excludable from gross income each year in which twelve payments are received (78% of $1,200)*

 $936

Amount includable in gross income ($1,200 – 936)*

$264

   

*Since the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract; after that has been recovered, the remaining amounts received are includable in income.

7. How are payments under a variable immediate annuity taxed?

Both fixed dollar and variable annuity payments received as an annuitized stream of income are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser’s investment, and the balance is taxable as ordinary income. In the case of a variable annuity, however, the excludable portion is not determined by calculating an “exclusion ratio” as it is for a fixed dollar annuity. Because the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. Thus, the excludable portion of each payment is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid. In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.

If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If payments are to be made for a single life, the divisor is the appropriate life expectancy multiple from Table I or Table V, whichever is applicable (depending on when the investment in the contract was made, as explained here). If payments are to be made on a joint and survivor basis, based on the same number of units throughout both lifetimes, the divisor is the appropriate joint and survivor multiple from Table II or Table VI, whichever is applicable (depending on when the investment in the contract is made). IRS regulations explain the method for computing the exclusion where the number of units is to be reduced after the first death. The life expectancy multiple need not be adjusted if payments are monthly. If they are to be made less frequently (annually, semi-annually, quarterly), the multiple must be adjusted (see Frequency of Payment Adjustment Table).

A portion of each payment is only excluded from gross income using the exclusion ratio until the investment in the contract is recovered (normally, at life expectancy). However, if payments received are from an annuity with a starting date that was before January 1, 1987, payments continue to receive exclusion ratio treatment for life, even if the total cost basis recovered exceeds the original investment amount.

Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of the year’s exclusion. 

If an annuity settlement provides a period-certain or refund guarantee, the investment in the contract must be adjusted before being prorated over the payment period.

8. If payments from an immediate variable annuity drop below the excludable amount for any year, is the balance of the exclusion lost?

No.

If the amount received from an immediate variable annuity in any taxable year is less than the excludable amount as originally determined, the annuitant may elect to redetermine the excludable amount in a succeeding taxable year in which the annuitant receives another payment. The aggregate loss in exclusions for the prior year (or years) is divided by the number of years remaining in the fixed period or, in the case of a life annuity, by the annuitant’s life expectancy computed as of the first day of the first period for which an amount is received as an annuity in the taxable year of election. The amount so determined is added to the originally determined excludable amount.

Planning Point: In essence, this rule allows any investment in the contract not received in one year to be recovered pro-rata in subsequent years as subsequent payments are received. 

Example 5: Mr. Brown is sixty-five years old as of his birthday nearest July 1, 1985, the annuity starting date of a contract he purchased for $21,000. There is no investment in the contract after June 30, 1986. The contract provides variable monthly payments for Mr. Brown’s life. Because Mr. Brown’s life expectancy is fifteen years (Table I), he may exclude $1,400 of the annuity payments from his gross income each year ($21,000 ÷ 15). Assume that in each year before 1988, he receives more than $1,400, but in 1988, he receives only $800 – $600 less than his allowable exclusion. He may elect, in his return for 1989, to recompute his annual exclusion. Mr. Brown’s age, as of his birthday nearest the first period for which he receives an annuity payment in 1989 (the year of election) is sixty-nine, and the life expectancy for that age is 12.6. Thus, he may add $47.61 to his previous annual exclusion, and exclude $1,447.61 in 1989 and subsequent years. This additional exclusion is obtained by dividing $600 (the difference between the amount he received in 1988 and his allowable exclusion for that year) by 12.6.

Example 6: Mr. Green purchases a variable annuity contract that provides payments for life. The annuity starting date is June 30, 2012, when Mr. Green is 64 years old. Mr. Green receives a payment of $1,000 on June 30, 2013, but receives no other payment until June 30, 2015. Mr. Green’s total investment in the contract is $25,000. Mr. Green’s pre-July 1986 investment in the contract is $12,000. Mr. Green may redetermine his excludable amount as above, using the Table V life expectancy. If, instead, he elects to make separate computations for his pre-July 1986 investment and his post June-1986 investment, his additional excludable amount is determined as follows.

Pre-July 1986 investment in the contract allocable to taxable years 2013 and 2014 ($12,000 ÷ 15.1 [multiple from Table I for a male age 64] = $794.70;

$1,589.40

Less: portion of total payments allocable to pre-July 1986 investment in the contract actually received as an annuity in 2013 and 2014 ($12,000/$25,000 x $1,000)

$480.00 

Difference ($1,580.40-$480.00)

$1,109.40

 

Post-June 1986 investment in the contract allocable to taxable years 2013 and 2014 ($13,000 ÷ 20.3 [multiple from Table V for male age 64] = $640.39; 
$640.39 x 2 years = $1,280.78

 

$1,280.78

Less portion of total payments allocable to post-July 1986 investment in the contract actually received as an annuity in 2013 and 2014 ($13,000/$25,000 x $1,000)

$520.00

Difference ($1,280.78-$520.00)

$760.78

   

Because the applicable portions of the total payment received in 2013 under the contract ($480 allocable to the pre-July 1986 investment in the contract and $520 allocable to the post-June 1986 investment in the contract) do not exceed the portion of the corresponding investment in the contract allocable to the year ($794.70 pre-July 1986 and $640.39 post-June 1986), the entire amount of each applicable portion is excludable from gross income and Mr. Green may redetermine his excludable amounts as follows:

Divide the amount by which the portion of total payment actually received allocable to pre-July 1986 investment in the contract is less than the pre-July 1986 investment in the contract allocable to 2013 and 2014 ($1,109.40) by the life expectancy under Table I for Mr. Green, age 66 (14.4 – .5 [frequency multiple]; $1,109.40 ÷ 13.9)

$79.81

Add the amount originally determined with respect to pre-July 1986 investment in the contract

$794.70

Amount excludable with respect to pre-July 1986 investment

$874.51

Divide the amount by which the portion of total payment actually received allocable to post-June 1986 investment in the contract is less than the post-June 1986 investment in the contract allocable to 2013 and 2014 ($760.78) by the life expectancy under Table V for Mr. Green, age 66 (19.2 – .5 [frequency multiple]; $760.78 ÷ 18.7)

$40.68

Add the amount originally determined with respect to post-June 1986 investment in the contract

$640.39

Amount excludable with respect to post-June 1986 investment

$681.07

   

 

9.  Can a taxpayer purchase both QLACs and non-QLAC DIAs within an IRA and remain eligible to exclude the QLAC value when calculating RMDs? How is the non-QLAC DIA treated in such a case?

The regulations answer this question by their focus: Only QLACs are addressed within the regulations. IRA-held DIAs that are not QLACs are not governed by the new regulations. These regulations are additive in that they do not remove any of the previously existing rules that govern these types of annuity contracts. As a result, the regulations do not prevent a taxpayer from holding a non-QLAC DIA in a traditional IRA. In such a case, the previously existing method for determining RMDs for non-QLAC DIAs will apply.

The Actuarial Present Value (APV, which may be referred to as Fair Market Value, or FMV) is calculated and RMDs attributable to that value must be withdrawn from another IRA or through a commutation liquidation from the DIA contract itself. After the annuity starting date, the income payments from the DIA automatically satisfy the RMD requirement. No separate calculation is required.

10. What are the new rules that allow 401(k) plan sponsors to include deferred annuities in target date funds?

IRS Notice 2014-66 specifically permits 401(k) plan sponsors to include deferred annuities within TDFs without violating the nondiscrimination rules that otherwise apply to investment options offered within a 401(k). This is the case even if the TDF investment is a qualified default investment alternative (QDIA) — which is a 401(k) investment that is selected automatically for a plan participant who fails to make his or her own investment allocations.

Further, the guidance clarifies that the TDFs offered within the plan can include deferred annuities even if some of the TDFs are only available to older participants—even if those older participants are considered “highly compensated” — without violating the otherwise applicable nondiscrimination rules. Similarly, the nondiscrimination rules will not be violated if the prices of the deferred annuities offered within the TDF vary based on the participant’s age. 

The new guidance will allow plan sponsors to include annuities within TDFs even if a wide age variance exists among the plan’s participants. Additionally, the new rules allow plan sponsors to provide a participant with guaranteed lifetime income sources even if the participant is not actively making his or her own investment decisions with respect to plan contributions — a situation which is increasingly prevalent as employers may now automatically enroll an employee in the 401(k) plan unless the employee actively opts out of participation.

11. Can a taxpayer combine a deferred income annuity with a traditional annuity product? 

Yes. Insurance carriers have begun offering optional riders that can be attached to variable annuity products in order to include the benefits of a deferred income annuity within the variable annuity. These deferred income annuities allow the contract owner to withdraw portions of the variable annuity itself in order to fund annuity payouts late into retirement.

Taxpayers must purchase the rider at the time the variable annuity is purchased and can then begin transferring a portion of the variable annuity accumulation into the deferred income component as soon as two years after the contract is purchased. When the taxpayer begins making transfers into the deferred component, he or she must also choose the beginning date for the deferred payments.

The deferral period can be as brief as two years or, in some cases, as long as forty years, giving taxpayers substantial flexibility in designing the product to meet their individual financial needs. Further, taxpayers can choose to transfer as little as around $1,000 at a time or as much as $100,000 to build the deferred income portion more quickly.

The deferred income annuity rider can simplify taxpayers’ retirement income planning strategies in several important ways, not the least of which involves the ability to gain the benefits of both variable and deferred income annuities within one single annuity package.

This single-package treatment also allows taxpayers to avoid the situation where they wish to transition their planning strategies to eliminate the investment-type features common to variable annuity products into a product that allows for a definite income stream — a situation that commonly arises around the time when a taxpayer retires.

Without the combination product, the taxpayer would traditionally be required to execute a tax-free exchange of the variable annuity contract for a deferred income annuity. Instead, the deferred income annuity rider allows the taxpayer to systematically transfer funds from the variable portion of the contract into the deferred income portion over time (though lump sum transfers are also permissible).

12. Can a grantor trust own an annuity contract? How is an annuity owned by a grantor trust taxed? 

 

A grantor trust can own an annuity contract, but, in certain circumstances, the “non-natural person rule” of IRC Section 72(u) will cause the denial of the tax-deferral benefits to an annuity owned by a trust. If annuity tax benefits are denied under the non-natural person rule, income on the annuity for any taxable year will be treated as ordinary income received or accrued by the taxpayer for that tax year. However, if a trust owns an annuity contract as the agent for a natural person, Section 72(u) does not apply.

A revocable grantor trust will usually fall within this exception because the grantor (presumably a natural person) and the grantor trust are treated as one “person” for income tax purposes, and moreover because the property is generally held in trust specifically for that grantor. More generally, as long as the grantor trust (a non-natural person) owns the annuity contract, and the primary beneficiaries are natural persons, the annuity contract should escape the non-natural person rule of Section 72(u). If significant interests in the trust are held by non-natural persons, however, it is possible that the trust will not qualify as an agent for a natural person. 

If the grantor trust is irrevocable, determining whether the trust is exempt from the non-natural person rule becomes more complicated because the grantor of the trust might not retain any right to the trust assets or income. In making the determination whether significant interests in the trust are held by natural or non-natural persons, it is important to determine who will receive the primary economic benefit of the trust assets.

The IRS has ruled privately that annuity contracts owned by an irrevocable grantor trust established by an employer-corporation (a non-natural person) were held for the benefit of natural persons (the employees) because (1) the employee-beneficiaries of the trust would receive all of the trust income and (2) the employer held no future interest in the trust assets.Therefore, even though the actual grantor of the trust was a non-natural person, the annuity contract was able to escape the non-natural person rule because the beneficiaries were natural persons. 

Note that immediate annuities are explicitly exempted from the non-natural person rule of IRC Section 72(u).