523 / 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.¹ The penalty tax potentially applies to any payment received to the extent the payment is includable in income unless an exception applies. 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;²

(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 (see Q 524);

(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; see Q 3677, IRA; Q 3964, pension, profit sharing, stock bonus; Q 4069, 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;³

(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).

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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 15 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, Ameritas®.

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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.⁴

Apparently, if an annuity contract was issued between August 13, 1982 and January 19, 1985, a distribution of income allocable to any investment made 10 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.⁵ To facilitate accounting, investments are considered made on January 1 of the year in which they are invested.⁶

There also is a 10 percent penalty tax on certain premature distributions from life insurance policies classified as modified endowment contracts ( Q 13).

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.