An annuity is a complicated beast — and during tax season, your clients' questions can pile up faster than hospitality complaints from the crowds at Sochi. How are payments under a variable immediate annuity taxed? When is the exchange of one annuity contract for another a nontaxable exchange? Read on to find answers to these and other queries.
1. What general rules govern the income taxation of payments received under annuity contracts?
The rules in IRC Section 72 govern the income taxation of all amounts received under nonqualified annuity contracts.(Nonqualified annuities are annuities that are not held within a “qualified” retirement plan or an IRA.) IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns. Qualified annuity contracts are governed by the tax rules of the retirement account in which they are held.
2. How are annuity contracts held by corporations and other non-natural persons taxed?
Except as noted below, to the extent that contributions are made after February 28, 1986 to a deferred annuity contract held by a corporation or another entity that is not a natural person, the contract is not treated for tax purposes as an annuity contract.
When an annuity contract is no longer treated as an annuity for tax purposes, income on the contract is treated as ordinary income received or accrued by the owner during the taxable year. “Income on the contract” is the excess of (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (the amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement.
3. How can the investment in the contract be determined for purposes of the annuity rules?
Generally speaking, the investment in the contract is the gross premium cost or other consideration paid for the contract, reduced by amounts previously received under the contract to the extent they were excludable from income.
Unless the contract has been purchased from a previous owner, the investment in the contract normally is premium cost. It is not equal to the policy’s cash value.
4. 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. 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. This deduction, in most cases, will be small. Generally, it 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. 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 prorated 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.
5. If an annuitant dies before receiving the full amount guaranteed under a refund or period-certain life annuity, is the balance of the guaranteed amount taxable income to the refund beneficiary?
The beneficiary will have no taxable income until the total amount the beneficiary receives, when added to amounts that were received tax-free by the annuitant (i.e., the excludable portion of the annuity payments), exceeds the investment in the contract. In other words, all amounts received by the beneficiary under a refund guarantee are exempt from tax until the investment in the contract has been recovered tax-free. Thereafter, receipts (if any) are taxable income. For purposes of calculating the unrecovered investment in the contract, the value of the refund or guarantee feature is not subtracted. This “FIFO” treatment, for payments made to the beneficiary, is different from the “regular annuity rules” treatment that applied to payments made to the deceased annuitant.
The amount received by the beneficiary is considered paid in full discharge of the obligation under the contract in the nature of a refund of consideration and therefore comes under the cost recovery rule regardless of when the contract was entered into or when investments were made in the contract. This rule applies whether the refund is received in one sum or in installments made under the same payout arrangement under which the deceased annuitant had been receiving payments.
6. Is the purchaser of a deferred variable annuity taxed on the annual growth of a deferred annuity during the accumulation period?
An annuity owner who is a “natural person” will pay no income tax until he or she receives distributions from the contract. If the contract is annuitized, taxation of payments will be calculated based on the rules that apply given the annuity starting date when payments begin. Distribution amounts received “not as an annuity” — i.e., partial withdrawals or full surrenders without annuitization — prior to the annuity starting date are subject to the rules discussed here and here.
The tax deferral enjoyed by a deferred annuity owned by a natural person is not derived from any specific IRC section granting such deferral. Rather, this tax treatment is granted by implication. All distributions from an annuity are either “amounts received as an annuity” or “amounts not received as an annuity.” As the annual growth of the annuity account balance, except to the extent of dividends, is not stated in the IRC to be either, it is not a “distribution,” and therefore is not subject to tax as earned.
8. When is a policy owner deemed to have exchanged one annuity contract for another?
Under IRC Section 1035, policy owners may exchange one annuity contract for another on a tax-deferred basis.
However, the distinction between an “exchange” and a surrender-and-purchase is not always clear. Where the contract is assignable, the IRS has required a direct transfer of funds between insurance companies. In addition, the “exchange” of an annuity contract received as part of a distribution from a terminated profit-sharing plan for another annuity with similar restrictions as to transferability, spousal consent, minimum distribution, and the incidental benefit rule was granted IRC Section 1035 treatment. In addition, the IRS has ruled privately that the surrender of a non-assignable annuity contract distributed by a pension trust and immediate endorsement of the check by the annuitant to the new insurer in a single integrated transaction under a binding exchange agreement with the new insurer qualified as an exchange.
9. When is the exchange of one annuity contract for another a nontaxable exchange?
The IRC provides that the following exchanges are nontaxable:
10. What distributions are required when the owner of an annuity contract dies before the entire interest in the contract has been distributed?
A deferred annuity contract issued after January 18, 1985, will not be treated as an “annuity contract” and taxed under the favorable provisions of IRC Section 72 unless it provides that if any owner dies –
- on or after the annuity starting date (in other words, when the annuity was in “payout status”) and before the entire interest in the contract has been distributed, the remaining portion will be distributed at least “as rapidly as under the method of distribution being used as of the date of the owner’s death,” and
- before the annuity starting date, the entire interest in the contract will be distributed within five years after the owner’s death, unless either of two exceptions applies.
In the case of joint owners of a contract issued after April 22, 1987, these distribution requirements are applied at the first death.
11. How are damage payments taxed if an annuity is used to fund a judgment or settle a claim for damages on account of personal injuries or sickness?
Other than punitive damages, any damages received on account of personal physical injuries or physical sicknesses are not includable in gross income. This is true whether the damages are received by suit or agreement or as a lump sum or periodic payments. For this purpose, emotional distress is not treated as a physical injury or physical sickness.