Old IRS tables clash with current annuity pricing

None of the annuity income is taxable until the entire premium cost has been recovered. How long will this take? If the cost basis is $100,000 and the monthly annuity payment rate is $695 the premium cost recovery duration is 143.88 months ($100,000/$695) or about 12 years.

This effectively gives this person a "first-in-first out" or "FIFO" annuity income tax treatment for 12 years. The immediate annuity internal deferral of the taxable gains won't come into play until after this time when the entire annuity income becomes taxable. Generally for cash payment purchase transactions, annuity FIFO taxation and utilization of an internal taxable income deferral hasn't been available for annuity premiums paid after August 13, 1982.

Regarding this contract variability and under current annuity pricing, generally this type of tax treatment is possible for males age 76 and females age 72 and over. Females start younger because the life insurance companies estimate longer female life expectancies vs. their male counter parts and therefore reduce female annual annuity incomes accordingly. However, both genders are compelled to use the same IRS Table V numbers.

Let's consider temporary life annuities. A temporary life annuity is also a life contingent annuity but the payments are limited to a set number of years. For example, a 10-year (120 months) contract will produce annual income until death or the completion of 10-years whichever occurs first. While, there are a multitude of uses for temporary life annuities, we are only addressing the income tax issues here. Many individuals just assume the annuity premium cost recovery is spread over the 10-year payment duration. However, this is not the case! In this example, the IRS uses Table VIII. For a person age 80, this table calls for a premium cost recovery rate of 7.50 years (90 months).

This means individuals, in this example age 80, get to cram all the tax basis recovery into the first 7.50 contract years even though they have a 10-year payment contract. Of course, the shorter the cost basis recovery period, the greater the annual recovery rate vs. the actual annuity annual income payment.

When doing income tax and income planning for your clients in 2015, don't forget these very tax efficient and guaranteed contracts. Given where we are regarding current annuity pricing and the old IRS rules and tables, you can really generate rich non-taxable income sources. That's the idea. Always keep your hands up.