544 / What are the income tax consequences to the surviving annuitant under a joint and survivor annuity?

The survivor continues to exclude from gross income the same percentage of each payment that was excludable before the first annuitant’s death. With respect to annuities having a starting date after December 31, 1986, the total exclusion by the first annuitant and the survivor may not exceed the investment in the contract; that is, when the entire investment in the contract has been received tax-free, the entire amount of all subsequent payments will be taxed as ordinary income ( Q 540 to Q 543). However, for annuities with starting dates prior to January 1, 1987, the exclusion ratio continues to apply indefinitely to annuity payments, even if the amount of principal recovered exceeds the original investment in the contract.

In addition, if the value of the survivor annuity was subject to estate tax, the survivor may be entitled to an income-in-respect-of-a-decedent income tax deduction for a portion of the estate tax paid (attributable to the embedded gain in the contract at the time of death).¹ This deduction, in most cases, will be small.

Generally, the income-in-respect-of-a-decedent deduction is computed as follows: The portion of the guaranteed annual payment that will be excluded from the survivor’s gross income (under the exclusion ratio) is multiplied by the survivor’s life expectancy at the date of the first annuitant’s death. The result is subtracted from the estate tax value of the survivor’s annuity, thereby determining the amount of expected gain in the contract at death. The total income tax deduction allowable is the estate tax attributable to this remainder of the value of the survivor’s annuity.

This total deduction is claimed pro-rata over the survivor’s life expectancy as of the date of the first annuitant’s death, and a prorated amount is deductible from the survivor’s gross income each year as payments are received. But no further deduction is allowable after the end of the survivor’s life expectancy. The foregoing treatment applies only where the primary annuitant died after 1953.²

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Planning Point: Joint ownership of non-qualified annuities creates more problems than it solves, including forced distribution at either owner’s death. Where the designated beneficiary of each owner is other than the other owner, payment, at either owner’s death, generally will be made to that beneficiary, effectively (and surprisingly) “disinheriting” the surviving owner. Some annuity contracts contain language stating that if the contract is jointly owned (with a right of survivorship), the surviving owner will be deemed to be the deceased owner’s primary beneficiary, notwithstanding any beneficiary designation to the contrary. Some insurers will not issue deferred annuities with joint ownership unless the owners are a married couple.