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.

Of course, if the contract owner takes a lump sum settlement at maturity, the contract owner must include the gain in gross income for the year in which he or she receives the payment.

Are there any considerations that a taxpayer should be made aware of when deciding whether to surrender an annuity or accept a buyback offer?

Taxpayers who purchased variable annuities with a view toward generating retirement income may be facing buyout offers from an issuing insurance company, notices that their investment choices are being limited to those that are very conservative, or may simply find themselves facing changed circumstances so that the product no longer makes sense.

For example, a taxpayer who has recently been diagnosed with a disease that is likely to shorten his or her life expectancy may find that surrendering the annuity in exchange for a lump sum payout may better serve his or her reduced need for lifetime income. Other taxpayers may be facing unanticipated expenses and see the buyout as a way to meet those expenses.

Taxpayers facing the need for an immediate lump sum of cash should also be aware that it may be possible for them to withdraw a portion of the annuity’s assets, keeping only a small part of the initial investment in the annuity to maintain the contract’s death benefit. Taxpayers who are simply unhappy with the variable annuity’s investment performance may also find this strategy appealing, as they can then invest in another income-producing product while preserving some value in the original annuity.

For taxpayers who are still attracted to the income-producing feature of a variable annuity, however, it might be best to hold on to the product in the face of a buyout offer, especially if the product offers guaranteed returns that may be unavailable in a replacement product.

After a taxpayer has determined that his or her best interests will be served by surrendering the product, the surrender charges associated with the annuity still must be taken into account. If the taxpayer has a buyout offer on the table, it is likely that the insurance company has already offered to waive any surrender charges. If the taxpayer has independently decided to surrender, however, the taxpayer may be able to negotiate a waiver, especially if the taxpayer agrees to reinvest the recovered annuity funds with the same carrier that issued the surrendered product.

It is important that taxpayers realize they will owe taxes upon any gain realized at the time of surrender. If the taxpayer has only held the annuity product for a few years, this gain might not be substantial—in fact, many variable annuity products that were issued just before the economic downturn in 2008 are just now returning owners to the break-even point. Still, for taxpayers who have owned the variable annuity for many years, the tax liability can be substantial—especially when the new 3.8 percent investment income tax for high earning taxpayers is taken into account.

For taxpayers who purchased the annuity product within an IRA, the funds can be transferred in a trustee-to-trustee type rollover transaction, which allows the taxpayer to defer taxation until the funds are withdrawn from the IRA. Taxation can also be deferred if the taxpayer exchanges the undesirable annuity for another annuity product in a tax-free exchange under IRC Section 1035.

(Related: Qualified Longevity Annuity Contracts and Retirement Planning)