What are the income tax consequences when the owner of an annuity contract takes the lifetime maturity proceeds or cash surrender value in a lump sum cash payment?
Amounts received on complete surrender, redemption, or maturity are taxable to the extent that the maturity proceeds or cash surrender value exceed the investment in the contract The excess is taxable income in the year of maturity or surrender, even if the proceeds are not received until a later tax year.
The investment in the contract is the aggregate premiums or other consideration paid for the annuity minus amounts paid out that were excluded from income (and/or any dividends received). The gain is ordinary income, not capital gain, and thus cannot be netted against capital losses.
Some commentators and some insurers have taken the position that the gain on total surrender of a deferred annuity equals the cash value prior to surrender, without regard to surrender charges, less the taxpayer’s investment in the contract.
Example: John’s deferred annuity has a current cash value of $110,000, to which a surrender charge of $10,000 applies. His investment in the contract is $100,000. The position described above holds that if John surrenders the contract now for its net surrender value of $100,000, he will recognize a gain of $10,000 (the cash value of the contract prior to surrender, without regard to surrender charges, less his investment in the contract).
This application of Section 72(e)(3)(A) is incorrect; it applies only in the case of partial surrenders. In the case of a full surrender, IRC Section 72(e)(5) states that in the case of “full refunds, surrenders, redemptions, & maturities,”…“the rule of paragraph 2(A) shall not apply”(for which rule, and only for which rule, the “without regard to surrender charges” condition of Section 72(e)(3)(A) exists).
(Related: Qualified Longevity Annuity Contracts and Retirement Planning)
The correct computation of John’s gain in the contract is the surrender value minus the amount actually received by John upon surrender, less investment in the contract ($100,000 – $100,000 = zero gain). However, if John had only taken out a partial withdrawal – e.g., $20,000 – the first $10,000 would be gain and the second $10,000 would be return of return (as with partial surrenders, gain is determined without regard to surrender charges).
Is the full gain on a deferred annuity or retirement income contract taxable in the year the contract matures?
If the contract provides for automatic settlement under an annuity option, the lump sum proceeds are not constructively received in the year of maturity; if the policy provides a choice of settlement options, the policy owner can opt out of the lump sum proceeds choice within 60 days and avoid constructive receipt. The annuity payments (whether life income or installment) are taxed under the regular annuity rules as they are received in the future. In computing the exclusion ratio for the payments, the amount to be used as the investment in the contract is premium cost, not the maturity value.