Q: What tax rules govern dividends, cash withdrawals, and other amounts received under annuity contracts before the annuity starting date?
A: Policy dividends (unless retained by the insurer as premiums or other consideration), cash withdrawals, amounts received as loans and the value of any part of an annuity contract pledged or assigned, and amounts received on partial surrender under annuity contracts entered into after August 13, 1982, are taxable as income to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract (i.e., to the extent there is gain in the contract).[1]
To the extent the amount received is greater than the gain, the excess is treated as a tax-free return of investment. In effect, this ordering treatment results in distributions being treated as interest or gains first and only second as recovery of cost. (In addition, taxable amounts may be subject to a 10 percent penalty tax unless paid after age 59½ or disability (Q 356).)
For the purpose of determining the taxable portion of a partial surrender, cash surrender value is determined without regard to any surrender charge.[2] This is not the case with regard to total surrenders. Investment in the contract is, under the general rule, reduced by previously received excludable amounts; however, if annuity loans are involved, investment in the contract is increased by loans treated as distributions to the extent the amount is includable in income, although not reduced to the extent it is excludable.[3]
Policy dividends, cash withdrawals, and amounts received on partial surrender under annuity contracts entered into before August 14, 1982 (and allocable to investment in the contract made before August 14, 1982) are taxed under the "cost recovery rule." Under the cost recovery rule, the taxpayer may receive all such amounts tax-free until the taxpayer has received tax-free amounts equal to his or her pre-August 14, 1982, investment in the contract; the amounts are taxable only after such basis has been fully recovered.[4]
Amounts received that are allocable to an investment made after August 13, 1982, in an annuity contract entered into before August 14, 1982, are treated as received under a contract entered into after August 13, 1982, and are subject to the "interest first" rule.[5] If an annuity contract has income allocable to earnings on pre-August 14, 1982, and post-August 13, 1982, investments, the amount received is allocable first to investments in the contract made prior to August 14, 1982, then to income accumulated with respect to such investments (under the "cost recovery" rule, see next paragraph), then to income accumulated with respect to investments made after August 13, 1982, and finally to contributions made after August 13, 1982, under the "interest-first" rule.[6]
Where, as part of the purchase of a variable annuity, a taxpayer entered into an investment advisory agreement that stated that the company issuing the annuity would be solely liable for payment of a fee to an investment adviser who would manage the taxpayer's funds in the variable accounts, the fee was considered to be an amount not received as an annuity and, thus, includable in the taxpayer's income to the extent allocable to the income on the contract.[7]
For tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long term care contract that is a rider to the annuity or life contract will not be included in the gross income of the taxpayer. The investment in the contract for the annuity or life contract will be reduced by the amount of the charge against the cash surrender value.[8]
Special rules applicable to amounts received under pension, profit sharing, or stock bonus plans, under annuities purchased by any such plan, or under IRC Section 403(b) tax sheltered annuities are discussed in Q 414 to Q 3731, and Q 3794. The rules applicable to loans under qualified plans and under tax sheltered annuity (IRC Section 403(b)) contracts are discussed in Q 3719 and Q 3786, respectively.
Transfers without adequate consideration
An individual who transfers any annuity contract issued after April 22, 1987, for less than full and adequate consideration will be treated as having received an "amount not received as an annuity" unless the transfer is between spouses or incident to a divorce under the IRC Section 1041 non-recognition rule. The amount the transferor will be deemed to have received is the excess of the cash surrender value of the contract at the time of the transfer over the investment in the contract at that time. The transferee's investment in the contract will be increased by the amount, if any, included in income by the transferor.[9]
Planning Point: This provision effectively prevents annuity owners from transferring their gain to another individual through gifting the annuity contract, because the gains embedded in the contract become taxable to the transferor at the time of transfer.
Other amounts
The purpose behind the "interest first" rule applicable to investment in contracts after August 13, 1982, is to limit the tax advantages of deferred annuity contracts to long term investment goals, such as income security, and to prevent the use of tax deferred inside build-up as a method of sheltering income on freely withdrawable short term investments.
Consistent with this purpose, other amounts that are neither interest payments nor annuities received under annuity contracts, regardless of when entered into, are not treated first as interest distributions but are taxed under the cost recovery rule. These amounts include lump sum settlements on complete surrender, annuity contract death benefits, and amounts received in full discharge of the obligation under the contract that are in the nature of a refund of consideration, such as a guaranteed refund under a refund life annuity settlement.[10]
Multiple contracts
All annuity contracts entered into after October 21, 1988, that are issued by the same company to the same policyholder during the same calendar year will be treated as one aggregated annuity contract for purposes of determining under the above rules the amount of any distribution that is includable in income.[11] An annuity that is received as part of an IRC Section 1035 exchange that was undertaken as part of a troubled insurer's rehabilitation process under Revenue Ruling 92-43 is considered to have been entered into for purposes of the multiple contract rule on the date that the new contract is issued. The newly-received contract is not "grandfathered" back to the issue date of the original annuity for this purpose.[12]
This aggregation rule does not apply to distributions received under qualified pension or profit sharing plans, from an IRC Section 403(b) contract, or from an IRA.[13] The Conference Report on OBRA '89 also states the aggregation rule does not apply to immediate annuities.
If the contract is owned by a corporation or other non-natural person, see also Q 354.
For amounts received under life insurance or endowment contracts, see Q 7. For distributions received under life insurance policies that are classified as modified endowment contracts, see Q 8.
Effect of tax-free exchange
To give effect to the grandfathering of pre-August 14, 1982, annuities, a replacement contract obtained in a tax–free exchange of annuity contracts succeeds to the status of the surrendered contract for purposes of determining when amounts are to be considered invested and for computing the taxability of any withdrawals.[14] Investment in the replacement contract is considered made on, before, or after August 13, 1982, to the same extent the investment was made on, before, or after August 13, 1982, in the replaced contract.
For more annuity tax facts, visit LifeHealthPro.com/taxplanning
.IRC Sec. 72(e).
