The tax landscape for annuity products is a challenge to navigate, even for experts. What penalties apply to premature distributions? What are the tax consequences if a client wishes to annuitize only a portion of an annuity contract? How is an annuity owned by a grantor trust taxed? And what about QLACs?
Prepare for your clients' questions — or simply test your knowledge — by reviewing this collection of 12 annuity tax facts. If you have unanswered questions on the taxation of annuities, let us know in the comments section below.
1. If an annuity is held by a trust or other entity as agent for a natural person, does the general rule that annuities held by non-natural persons are not taxed as annuities apply?
An annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person. If a non-natural person is the nominal owner of an annuity contract but the beneficial owner is a natural person, the annuity contract will be treated as though held by a natural person. Also, an annuity owned by a grantor trust will be considered to be owned by the grantor of the trust.
In Private Letter Ruling (PLR) 9204014, the IRS decided that a trust was considered to hold an annuity contract as an agent for a natural person where the trust owned an annuity contract which was to be distributed, prior to its annuity starting date, to the trust's beneficiary, a natural person.
See also: 6 trusts you should know about
In PLR 199905015, the IRS considered an irrevocable trust whose trustee purchased three single premium deferred annuities, naming the trust as owner and beneficiary of the contracts and a different trust beneficiary as the annuitant of each contract. The terms of the trust provided that the trustee would terminate the trust and distribute an annuity to each trust beneficiary after a certain period of time. The IRS held that the non-natural person rule was not applicable.
Additionally, in PLR 972035 the IRS concluded that the non-natural person rule does not apply to a trust that had invested trust assets in a single premium deferred variable annuity where the same individual was the sole annuitant under the contract and the sole life beneficiary of the trust.
PLR 9639057 set forth the rule that where a trustee's duties were limited to purchasing an annuity as directed by an individual and holding legal title to the annuity for that individual's sole benefit and the trustee was not able to exercise any rights under the annuity contract unless directed to do so by the individual, the IRS concluded that the trustee was acting as an agent for a natural person.
Further, where the trustee of an irrevocable trust purchased an annuity and had the power to select an annuity settlement option or terminate the annuity contract, the annuity was still considered to be owned by a natural person in PLR 199933033.
However, in PLR 9009047 a charitable remainder unitrust was not considered to hold an annuity contract as an agent for a natural person and, thus, was required to include income on any annuity contracts in ordinary income each year.
Although it is not entirely clear that all permissible beneficiaries of a trust named as owner of a deferred annuity must be natural persons, it is significant that, as of June 2010, all private letter rulings addressing whether a trust named as owner of a deferred annuity was acting as "the agent of a natural person" have specified that all beneficiaries were, in fact, natural persons.
If all beneficiaries of a trust owning a deferred annuity must be natural persons, must the term "beneficiary" be taken literally? In the case of a "special needs" trust (such as an OBRA "D(4)(A)" trust), it is not clear whether the position of creditor occupied by the state Medicaid agency (to the extent of any Medicaid payments made to the trust beneficiary) will constitute the interest of a "beneficiary," where the state Medicare statute does not specify that the state's interest is that of a "beneficiary."
2. What penalties apply to "premature" distributions under annuity contracts?
To discourage the use of annuity contracts as short term tax sheltered investments, a 10 percent tax is imposed on certain "premature" payments under annuity contracts. The penalty tax potentially applies to any payment received to the extent the payment is includable in income. Exceptions to the penalty tax include:
(1) any payment made on or after the date on which the taxpayer becomes age 59½;
(2) any payment made on or after the death of the holder (or the primary annuitant in the case where the holder is a non-natural person);
(3) any payment attributable to the taxpayer's becoming disabled;
(4) any payment made under an immediate annuity contract;
(5) any payment that is part of a series of substantially equal periodic payments (SEPPs) made (not less frequently than annually) for the life or life expectancy of the taxpayer or the joint lives or joint life expectancies of the taxpayer and his or her designated beneficiary;
(6) any payment made from a qualified pension, profit sharing, or stock bonus plan, under a contract purchased by such a plan, under an IRC Section 403(b) tax sheltered annuity, from an individual retirement account or annuity, or from a contract provided to life insurance company employees under certain retirement plans (but such payments are subject to similar premature distribution limitations and penalties; IRA; pension, profit sharing, stock bonus; tax sheltered annuity);
(7) any payment allocable to investment in the contract before August 14, 1982, including earnings on a pre-August 14, 1982 investment;
(8) any payment made from an annuity purchased by an employer upon the termination of a qualified plan and held by the employer until the employee's separation from service; or
(9) any payment under a qualified funding asset (i.e., any annuity contract issued by a licensed insurance company that is purchased as a result of a liability to make periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness).
Planning Point: SEPPs. From a practical standpoint, it would appear imprudent for an individual younger than age 45 to attempt to qualify for the exception for substantially equal periodic payments. A period longer than fifteen years may afford too much time in which a "material change" could occur. Also, the taxpayer might forget the importance of continuing to satisfy the conditions for this exception to the penalty tax. — Fred Burkey, CLU, APA, The Union Central Life Insurance Company.
Where a deferred annuity contract was exchanged for an immediate annuity contract, the purchase date of the new contract for purposes of the 10 percent penalty tax was considered to be the date upon which the deferred annuity was purchased. Thus, even if the new contract had been immediately annuitized, payments from the replacement contract did not fall within the immediate annuity exception to the penalty tax.
Also, if an annuity contract was issued between August 13, 1982 and January 19, 1985, a distribution of income allocable to any investment made ten or more years before the distribution is not subject to the penalty. For this purpose, amounts includable in income are allocated to the earliest investment in the contract to which amounts were not previously fully allocated. To facilitate accounting, investments are considered made on January 1 of the year in which they are invested.
There also is a 10 percent penalty tax on certain premature distributions from life insurance policies classified as modified endowment contracts.
The tax on premature distributions is not taken into consideration for purposes of determining the nonrefundable personal credits, general business credit, or foreign tax credit.
3. What are the tax consequences if a taxpayer wishes to annuitize only a portion of an annuity contract?
Previously, the owner of an annuity or life insurance contract who wanted to annuitize a portion of a contract was required to split a contract into two and annuitize one of the resulting contracts. Splitting the contract was treated as a partial withdrawal and the owner was taxed prior to annuitization. As of 2011, that cumbersome two-step process is no longer necessary.
This result is due to the passage of the Small Business Jobs and Credit Act of 2010, (H.R. 5297). Section 2113 of the law amended IRC Section 72(a) to permit partial annuitization of annuity, endowment, and life insurance contracts — leaving the balance unannuitized — as long as the annuitization period is for ten years or more or is for the lives of one or more individuals.
When a contract is partially annuitized: (1) each annuitized portion of the contract is treated as a separate contract; (2) for purposes of calculating the taxable portion of annuity payments from a partially annuitized contract, investment in the contract is allocated pro rata between each portion of the contract from which amounts are received as an annuity and the portion of the contract from which amounts are not received as an annuity; and (3) each separately annuitized portion of the contract will have a separate annuity start date.
Partial annuitization is permissible for tax years beginning after December 31, 2010.
4. How is expected return on a non-variable annuity computed under the annuity rules?
Generally speaking, expected return is the total amount that the annuitant or annuitants can expect to receive over the annuitization period of the contract.
If payments are for a fixed period or a fixed amount with no life expectancy involved, expected return is the sum of the guaranteed payments.
If payments are to continue for a life or lives, expected return is derived by multiplying the sum of one year's annuity payments by the life expectancy of the measuring life or lives. The life expectancy multiple or multiples must be taken from the Annuity Tables prescribed by the IRS. (See here for IRS Annuity Tables).
Generally, gender-based Tables I – IV are to be used if the investment in the contract does not include a post-June 30, 1986 investment. Unisex Tables V – VIII are to be used if the investment in the contract includes a post-June 30, 1986 investment. Transitional rules permit an irrevocable election to use the unisex tables even where there is no post-June 1986 investment and, if investment in the contract includes both a pre-July 1986 investment and a post-June 1986 investment, an election may be made in some situations to make separate computations with respect to each portion of the aggregate investment in the contract using, with respect to each portion, the tables applicable to it.
The life expectancy for a single life is found in Table I or in Table V, whichever is applicable. The life expectancy multiples for joint and survivor annuities are taken from Tables II and IIA or Tables VI and VIA, whichever are applicable.
The Annuity Tables are entered with the age of the measuring life as of his or her birthday nearest the annuity starting date. The multiples in the Annuity Tables are based on monthly payments. Consequently, where the annuity payments are to be received quarterly, semi-annually, or annually, the multiples from Tables I, II, and IIA or, as applicable, Tables V, VI, and VIA, must be adjusted. This adjustment is made by use of the Frequency of Payment Adjustment Table. No adjustment is required if the payments are monthly.
5. How is the excludable portion of payments under a single life annuity computed?
The following steps are taken in applying the basic annuity rule in order to determine the portion of payments that may be excludable from income in the case of a straight life annuity:
(1) Determine the investment in the contract.
(2) Find the life expectancy multiple in Table I or V, whichever is applicable for a person of annuitant's age (and sex, if applicable). Multiply the sum of one year's guaranteed annuity payments by the applicable Table I or Table V multiple. For non-variable contracts, this is the expected return under the contract. For variable contracts, the "expected return" is the investment in the contract divided by the number of years over which payments will persist.
(3) Divide the investment in the contract by the expected return under the contract, carrying the quotient to three decimal places. This is the exclusion ratio expressed as a percentage ("exclusion percentage").
(4) Apply the exclusion percentage to the annuity payment. The result is the portion of the payment that is excludable from gross income. The balance of the payment must be included in gross income. If the annuity starting date is after December 31, 1986, the exclusion percentage applies to payments received only until the investment in the contract is recovered. However, if the annuity starting date was before January 1, 1987, the same exclusion percentage applies to all payments received throughout the annuitant's lifetime.
Example 1: On October 1, 2015, Mr. Brown purchased an immediate non-refund annuity that will pay him $125 a month ($1,500 a year) for life, beginning November 1, 2015. He paid $16,000 for the contract. Mr. Brown's age on his birthday nearest the annuity starting date (October 1) was 68. According to Table V (which he uses because his investment in the contract is post-June 1986), his life expectancy is 17.6 years. Consequently, the expected return under the contract is $26,400 (12 × $125 × 17.6). The exclusion percentage for the annuity payments is 60.6 percent ($16,000 ÷ $26,400). Because Mr. Brown received two monthly payments in 2015 (a total of $250), he will exclude $151.50 (60.6 percent of $250) from his gross income for 2015, and he must include $98.50 ($250 – $151.50). Mr. Brown will exclude the amounts so determined for 17.6 years. In 2015, he could exclude $151.50; each year thereafter through 2031, he could exclude $909, for a total exclusion of $15,604.50 ($151.50 excluded in 2015 and $15,453 excluded over the next 17 years). In 2032, he could exclude only $395.50 ($16,000 – $15,604.50), which is all the investment in the contract he has left. In 2032, he would include in his income $1,104.50 ($1,500 – $395.50). In 2033 and each year thereafter, all cost basis has been recovered, and he would include $1,500 in income each year.
Example 2: If Mr. Brown purchased the contract illustrated above on October 1, 1986 (so that it had an annuity starting date before January 1, 1987), he would exclude $151.50 (60.6 percent of $250) from his 1986 gross income and would include $98.50 ($250 – $151.50). For each succeeding tax year in which he receives twelve monthly payments (even if he outlives his life expectancy of 17.6 years), he will exclude $909 (60.6 percent of $1,500), and he will include $591 ($1,500 – $909), even after 17.6 years' worth of payments have been made.
To calculate the excludable portion for an annuity contract with a refund or period-certain guarantee, see here.
6. How is the excludable portion of payments under an annuity with a single life refund or period-certain guarantee calculated?
The computations outlined in examples 1 and 2 in No. 6 above are for a straight life annuity (without a refund or period-certain guarantee). The exclusion ratio for a single life refund or period-certain guarantee is determined in the same way, but the investment in the contract first must be adjusted by subtracting the value of the refund or period-certain guarantee. The value of the refund or period-certain guarantee is computed by the following steps:
