How to gauge the income tax consequences of an annuity transaction

8) Death of the owner of a deferred annuity contract

There is NO step-up in cost basis to date of death value. The gain amount in excess of basis is “income in respect of decedent” (IRD) and is taxable income to the beneficiary (Rev. Rul. 2005-30; IRC Section 1014(b)(9)(A); IRC Section 691; IRC Section 72(s).

9) Withdrawals from a deferred annuity contract in a gain position

Withdrawals are first “LIFO” taxable income to the extent of the gain in the contract. Any remaining withdrawals are a tax free return of basis (IRC Section 72(e)(1)(2)(3).

10) Multiple deferred annuity contracts

If multiple deferred annuity contracts are issued by the same insurance carrier, to the same contract owner, during the same calendar year, they will fall under the “aggregation rule.” This means the multiple contracts will be treated as one annuity contract for purposes of any distribution that is includable in income (IRC Section 72(e)(12)). This “aggregation rule” does not apply to IRA annuities and Section 403(b) annuities.

11) Transfer of ownership of annuity contract under IRC Section 457(b) “eligible” deferred comp plan

If an annuity contract held by a non-profit organization is transferred from the non-profit to an employee, 100 percent of the account value is taxable income and the new cost basis to the employee is 100 percent of the account value.

12) Surviving spouse as post-death beneficiary of a deferred annuity

If a surviving spouse is beneficiary of a deferred annuity, he/she can take over the annuity and continue it as his/her own. The cost basis is “carryover basis” and the surviving spouse can name a new beneficiary (IRC Section 72(s)(3)). Surviving spouse can do a tax free Section 1035 exchange if desired and keep tax deferral going all the way until death of surviving spouse. 

13) Non-spouse as post-death beneficiary of a deferred annuity

If a non-spouse is beneficiary of a deferred annuity, they must elect a distribution payout either under the “five year rule” (IRC Section 72(s)(1)(B)) or the “life expectancy rule.” To qualify for a life expectancy payout, the beneficiary must make the election within one year of death. Cost basis is “carryover basis” for purposes of post-death distributions. The non-spouse may do a tax free Section 1035 exchange to a new annuity carrier if desired and permitted by the carriers, but must maintain the life expectancy payout method (PLR 201330016; IRC Section 72(s)(2)(B)). 

14) Pre-59 ½ withdrawals from a deferred annuity

Absent an exception, pre-59 ½ withdrawals from a deferred annuity in a gain position are subject to a 10 percent penalty tax. This penalty tax is only applied to the gain amount in excess of cost basis (IRC Section 72(q)(1)). 

15) Pre-59 ½ Section 1035 exchange from a deferred annuity to a SPIA

For this type of exchange, the new SPIA will have an exclusion ratio based on the “carryover basis” from the old deferred annuity. However, the taxable amount of each SPIA payment will also be subject to the 10 percent penalty tax until the client reaches age 59 ½ because the transaction does not qualify for the immediate annuity exception (Rev. Rul. 92-95; IRC Section 72(q)(2)(I)). 

The scenarios described herein are some of the more prominent and should be taken into consideration.