612 / If a qualified plan trust distributes an annuity contract to an employee, is the value of the contract taxable to the employee in the year of distribution?

Rather, the employee will be taxed on the annuity payments as he or she receives them ( Q 613, Q 618). A contract issued after 1962 must be nontransferable to qualify for this tax deferred treatment.² The transfer of an annuity to a divorced spouse pursuant to a divorce decree will not violate the nontransferability requirement.³

The IRS determined that the nontransferability requirement was not violated by a Section 1035 exchange of an annuity contract distributed from a qualified plan where the taxpayer simply was uncomfortable with the amount of funds invested with a single insurer.⁴ Both the old and new contracts were materially similar, were nontransferable, were subject to the spousal consent requirements, and met the other applicable IRC Section 401 requirements.⁵

If an employee surrenders an annuity contract after the year of distribution, the gain realized on surrender is taxable as ordinary income and will not qualify for taxation as a lump sum distribution.⁶ The unsurrendered annuity contract will affect the taxation of any lump sum distribution of which it is a part, or that is made in the same year, as explained below. If the annuity is surrendered in the year of distribution, the proceeds either will be taxed as ordinary income, or, if the distribution of the annuity is all or part of a lump sum distribution, under the lump sum distribution rules ( Q 3966). If an annuity is distributed in an eligible rollover distribution, tax may be deferred by rollover ( Q 3995).

According to proposed regulations, an employee’s cost basis is deducted first from the cash and property other than the annuity. Any excess is used to reduce the value of the annuity.⁷

Amounts that become payable in cash under qualified plans are not includable in income simply because they are available.⁸ Thus, where a plan provides that an employee, on termination of employment, may take either a single sum payment in cash or have the trustee purchase an annuity for the employee with cash, the employee’s election does not have to be made within any specific time after the cash became available. Plan distribution provisions must satisfy applicable distribution requirements ( Q 3890 to Q 3905).