While annuities are a viable solution to many clients' needs as they near retirement, it is crucial to advise each individual or entity of the applicable tax considerations.
Nonnatural-person ownership
Not all annuities are owned by individuals. Annuities purchased by contributions made to contracts after Feb. 28, 1986 and held by a corporation, family limited partnership (FLP), or another entity that is not a natural person, will not receive tax-deferred recognition on gain or income in the policy. IRC 72(e) income must be reported annually.
Congress ruled that prior law afforded companies the opportunity to fund large amounts of deferred compensation for select employees on a discriminatory basis. This situation created a disincentive to provide employees with qualified plans, which must follow ERISA guidelines.
A number of alternatives and exceptions to nonnatural-person classification exist when:
o A secular or rabbi trust is the owner of the annuity for the benefit of the employee (natural person).
o An annuity is acquired by the estate of a decedent by reason of the death of the owner/annuitant.
o An annuity is held in a qualified plan, such as a 401(k), 403(b), IRA, etc.
o An annuity is purchased by the employer upon termination of the qualified plan for benefit of the employee and will be distributed to the employee or beneficiary.
o An immediate annuity is purchased with single premium or annuity consideration, with the annuity starting date to be no later than one year from the date of purchase. The annuity provides substantially equal periodic payments at least annually during the annuity period.
o An annuity is purchased as a qualified funding asset in order to fund periodic payments by suit or agreement, on account of personal injury or sickness (IRC Section 130).
Joint ownership of an annuity between nonspouses
For joint ownership of an annuity between nonspouses, IRC 72 is very clear. Upon the death of one joint owner, the surviving owner must annuitize within one year of the death of the decedent, take distributions within five years, or take a lump-sum distribution.
Borrowing and collateral assignment
Individuals may borrow against the cash value of an annuity or use the annuity as collateral for a loan. Annuity contracts issued after Aug. 13, 1982 will trigger taxable income to the extent of gain in the policy and a possible 10 percent penalty if the owner is under age 591/2. This amount is subject to IRC 72 (e) (4) (LIFO).
1035 exchange for a pre-TEFRA annuity
The Tax Equity and Fiscal Responsibility Acts of 1982 and 1983 (TEFRA) called for substantial tax reform. In a 1035 exchange for a pre-TEFRA annuity without documentation for the basis before Aug. 14, 1982, FIFO (first-in/first-out) taxation will be lost. The entire amount is subject to LIFO (last-in/first out) taxation. Check the reported cost basis with the acquiring company in the transaction.
Multiple annuity policies' aggregation rule
The 72 (e) (11) aggregation rule, added to the 1983 Act, prevents an entity from acquiring multiple contracts with the same company during any calendar year and circumventing income-out-first rules. These annuities are considered serial annuities and are subject to Section 72 (e). All contracts are aggregated and treated as one policy for tax reporting (LIFO).
Partial 1035 exchanges
Today, most companies permit partial exchanges without recognition of gain to the annuity owner. However, special attention has to be given to determining cost basis for the existing and new annuity policies. Without proper documentation, additional taxes may have to be paid upon surrender of each annuity.
Registration of annuities
Let's assume a husband owns an annuity on his wife and names his son as beneficiary. Upon the wife's death, death proceeds are considered a taxable gift to the son. In this case, the husband can use his annual exclusion ($12,000) or apply his unified credit ($1 million).
Joseph F. Saskiewicz, MBA, CLU, ChFC, CFP of Holland, PA, is a financial consultant and registered investment advisor with the Pennsylvania Securities Commission. He has served as a part-time instructor for The American College and Penn State University. He can be reached at jsaskiewicz@comcast.net.
