Deferred annuities and single premium immediate annuities (SPIAs) are great financial vehicles for either tax deferred accumulation of a retirement fund or efficient distribution of principal and interest over life expectancy. However, over the lifetime of the contract owner, financial and estate planning situations occur that require a transaction to be executed on an existing annuity product.
These transactions could include annuitized settlement options, IRC Section 1035 exchanges, changes of ownership, payment to a beneficiary upon the death of the annuitant/owner, lifetime withdrawals from the annuity contract etc.
To determine the income tax consequences, if any, when an annuity transaction occurs requires a tracking and verification of the “investment in the contract.” We typically refer to this amount as the cost basis of the annuity.
Annuity Transactions with the Income Tax and Cost Basis Results:
1) Settlement option on an existing deferred annuity or the purchase of a new SPIA
Determine the “exclusion ratio” based on the cost basis (investment in the contract) and the expected return. Part of each annual payment will be excluded from income and part will be taxable income. Once the cost basis has been fully recovered, any remaining payments will be 100 percent taxable income (IRC Section 72(b)).
2) IRA Annuity
Generally, a qualified plan account like an IRA has a zero ($0) cost basis. Distributions from the IRA to the owner are 100 percent taxable income (IRC Section 72(e)(5)).
3) Transfer of ownership of a deferred annuity from one spouse to another
This type of transfer may occur for estate planning purposes or as a property settlement upon divorce. In these cases, the cost basis is “carryover basis” and the transaction is tax free with no current income taxes due (IRC Section 1041 and IRC Section 72(e)(4)(C)(ii)).
4) Transfer of IRA annuity upon divorce
Again, a transfer of an IRA annuity incident to divorce is a tax free transaction and the cost basis is “carryover” basis to the other spouse (IRC Section 408(d)(6)).
5) Gift of a deferred annuity contract to an adult child or an irrevocable trust
Upon this change of ownership, the gain amount is taxable income to the donor and the new cost basis for the donee is 100 percent of the account value (IRC Section 72(e)(4)(C)(i) and (iii)).
6) IRC Section 1035 exchange of one deferred annuity contract for multiple deferred annuity contracts
The exchange is tax free and the cost basis of the new contracts are allocated proportionally (IRC Section 1035(a)(3) and IRC Section 1031(d)).
7) IRC Section 1035 “partial exchange” of annuity contract
In this case, part of the annuity account is left with the existing carrier and part is exchanged to a new carrier. The exchange is tax free and there is a proportional allocation of cost basis between the old and new contracts (Rev. Rul. 2003-76).