Types of Annuities and Basic Tax Rules

March 13, 2024

4033 / What organizations can make tax sheltered annuities available to their employees?

<div class="Section1"> An organization must be either a tax-exempt organization of one of the types described in IRC Section 501(c)(3) or a public school system. An organization in either of these two categories may make tax sheltered annuity benefits available to one or more of its full-time or part-time employees. A participant must be an employee; persons working for an organization in a self-employed capacity generally are not eligible.<a href="#_ftn1" name="_ftnref1">1</a> A tax sheltered annuity also may be purchased for a duly ordained, commissioned, or licensed minister of a church by the minister himself if the minister is self-employed or by an organization that employs the minister and with respect to which the minister shares common religious bonds.<a href="#_ftn2" name="_ftnref2">2</a> This definition includes chaplains ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4052">4052</a>). IRC Section 501(c)(3) organizations are nonprofit organizations that are organized and operated exclusively for religious, charitable, scientific, literary, educational, or safety testing purposes, or for the prevention of cruelty to children or animals. Organizations other than public schools that are wholly owned by a state or other local government generally are not eligible employers. Some of these organizations will qualify as 501(c)(3) organizations if they are separately organized, are not an integral part of the government, and meet the description of a 501(c)(3) organization, such as some state or city hospitals.<a href="#_ftn3" name="_ftnref3">3</a> A school or college that is operated exclusively for educational purposes by a separate educational instrumentality may qualify doubly, both as a public school and as an IRC Section 501(c)(3) organization.<a href="#_ftn4" name="_ftnref4">4</a> A state department of education may qualify as a part of a public school system if its services involve the operation or direction of the state’s public school program.<a href="#_ftn5" name="_ftnref5">5</a> Likewise, a state agency that administers a guaranteed student loan program and is part of a state department of insurance may qualify.<a href="#_ftn6" name="_ftnref6">6</a> Thus, annuities may be purchased for employees of these organizations as well as public school teachers, teachers in private and parochial schools, school superintendents, college professors, clergymen, and social workers. A doctor who works as an employee for a hospital is eligible provided the hospital is a qualified employer. A doctor generally is not eligible, however, unless the doctor is an employee of the hospital for all purposes, such as Social Security and withholding tax purposes. If the doctor’s relationship to the hospital is that of an independent contractor, the doctor is not eligible and any premiums paid on the doctor’s behalf for an annuity will be currently taxable.<a href="#_ftn7" name="_ftnref7">7</a> Although teachers who are covered under a state teachers’ retirement system also may participate in a tax sheltered annuity plan, the employees of the retirement system itself are not eligible.<a href="#_ftn8" name="_ftnref8">8</a> The Uniformed Services University of the Health Sciences will be treated as a 501(c)(3) employer for purposes of providing tax sheltered annuities for employee members of a civilian faculty or staff with respect to service after December 31, 1979.<a href="#_ftn9" name="_ftnref9">9</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 403(b)(1). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC §§ 403(b)(1)(A)(iii), 414(e)(5). <a href="#_ftnref3" name="_ftn3">3</a>.  Rev. Rul. 55-319, 1955-1 CB 119, as modified by Rev. Rul. 60-384, 1960-2 CB 172; Rev. Rul. 67-290, 1967-2 CB 183. <a href="#_ftnref4" name="_ftn4">4</a>.  See Est. of Johnson v. Comm., 56 TC 944 (1971), acq., 1973-2 CB 2; Let. Rul. 7817098. <a href="#_ftnref5" name="_ftn5">5</a>.  Rev. Rul. 73-607, 1973-2 CB 145. <a href="#_ftnref6" name="_ftn6">6</a>.  See Let. Rul. 9438031. <a href="#_ftnref7" name="_ftn7">7</a>.  Rev. Rul. 66-274, 1966-2 CB 446; Rev. Rul. 70-136, 1970-1 CB 12; Azad v. U.S., 388 F.2d 74 (8th Cir. 1968); see also Rev. Rul. 73-417, 1973-2 CB 332; Ravel v. Comm., TC Memo 1967-182; Haugen v. Comm., TC Memo 1971-294. <a href="#_ftnref8" name="_ftn8">8</a>.  Rev. Rul. 80-139, 1980-1 CB 88. <a href="#_ftnref9" name="_ftn9">9</a>.  P.L. 96-613 § 104. </div></div>

March 13, 2024

4034 / How may a tax sheltered annuity plan be funded?

<div class="Section1"> Annuity Contracts. IRC Section 403(b) provides that the tax sheltered annuity rules apply if an annuity contract is purchased for an employee. Final regulations provide that an annuity contract means a contract that is issued by an insurance company qualified to issue annuities in a state and that includes payment in the form of an annuity.<a href="#_ftn1" name="_ftnref1">1</a> A custodial account also is treated as an annuity contract.<a href="#_ftn2" name="_ftnref2">2</a> In addition, retirement income accounts are treated as annuity contracts.<a href="#_ftn3" name="_ftnref3">3</a> An individual or group insurance company annuity contract that provides fixed retirement benefits may be used. A single group annuity contract that pools the assets of an employer’s tax sheltered annuity plan and defined contribution plan also may be used where the assets of each plan are separately accounted for at the plan level and at the participant level through the use of sub-accounts.<a href="#_ftn4" name="_ftnref4">4</a> The IRS has ruled that a variable annuity contract will qualify.<a href="#_ftn5" name="_ftnref5">5</a> A variable annuity contract in which the contract holder directs the investments in publicly available securities (i.e., mutual funds) will be treated as an annuity contract and the contract holder will not be treated as owning the underlying assets if certain conditions are met. For contracts intended to qualify as annuity contracts under IRC Section 403(b), that status will be granted if no additional federal tax liability would have been incurred if the employer of the contract holder had instead paid an amount into a custodial account in an arrangement under IRC Section 403(b)(7)(A). In other words, a contract holder will receive the same favorable tax treatment whether the investment in publicly available mutual fund shares is made through a mutual fund custodial account or variable annuity contract. The diversification rules under IRC Section 817(h) for variable annuity contracts are not applicable to IRC Section 403(b) contracts. The revenue procedure, which was effective on November 16, 1999, with respect to all taxable years, will not be applied adversely to an issuer or holder of a contract issued before November 16, 1999.<a href="#_ftn6" name="_ftnref6">6</a> Face Amount Certificates. The IRC expressly provides that so-called face amount certificates are to be treated as annuity contracts.<a href="#_ftn7" name="_ftnref7">7</a> Regulated Investment Company Stock. According to the final regulations, custodial account means a plan or a separate account under a plan in which an amount attributable to 403(b) contributions or an amount rolled over to a 403(b) contract is held by a bank or certain other entities, as discussed below, if: (1)  all of the amounts held in the account are invested in stock of a regulated investment company; (2)  the distribution restrictions that apply to custodial accounts are satisfied with respect to the amounts held in the account; (3)  the assets held in the account cannot be used for, or diverted to, purposes other than for the exclusive benefit of plan participants or their beneficiaries; and (4)  the account is not part of a retirement income account. The custodial account rule is not satisfied if the account includes any assets other than regulated investment company stock.<a href="#_ftn8" name="_ftnref8">8</a> The custodian must be a bank, insured federal credit union, building and loan association or other person satisfactory to the IRS.<a href="#_ftn9" name="_ftnref9">9</a> If the amounts are to be invested in regulated investment company stock to be held in that custodial account, and under the custodial account no amounts may be paid or available to any distributee (unless such amount is a distribution to which section 72(t)(2)(G) applies) before: (1)  the employee dies, (2)  the employee attains age 59½, (3)  the employee has a severance from employment, (4)  the employee becomes disabled, (5)  in the case of contributions made pursuant to a salary reduction agreement, the employee encounters financial hardship, or (6)  except as may be otherwise provided by regulations, with respect to amounts invested in a lifetime income investment, the date that is 90 days prior to the date that such lifetime income investment may no longer be held as an investment option under the contract, and in the case of amounts described (6), above, such amounts must be distributed only in the form of a qualified distribution or a qualified plan distribution annuity contract. State Teachers’ Retirement System. According to the final regulations, the requirement that a contract be issued by an insurance company qualified to issue annuities in a state does not apply if one of the following two conditions is, and continuously has been, satisfied since May 17, 1982: (1)  benefits are provided from a separately funded retirement reserve that is subject to supervision of the state insurance department, or (2)  benefits are provided from a fund that is separate from the fund used to provide statutory benefits payable under a state teachers’ retirement system to purchase benefits that are unrelated to the basic benefits provided under the retirement system, and the death benefit under the contract does not at any time exceed the larger of the reserve or the contribution made for the employee.<a href="#_ftn10" name="_ftnref10">10</a> Credit Union Share Accounts. The IRS takes the position that separate nonforfeitable share accounts in a credit union may not be considered annuity contracts for purposes of IRC Section 403(b).<a href="#_ftn11" name="_ftnref11">11</a> Retirement Income Accounts of Churches. Churches are permitted to maintain a retirement income account that will be treated as a tax sheltered annuity ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4052">4052</a>).<a href="#_ftn12" name="_ftnref12">12</a> According to the final regulations, a life insurance contract, endowment contract, health or accident contract, or property, casualty, or liability insurance contract do not meet the definition of an annuity contract.<a href="#_ftn13" name="_ftnref13">13</a> If a contract issued by an insurance company provides death benefits as part of the contract, however, that coverage is permitted assuming that those death benefits do not cause the contract to fail to satisfy any requirement applicable to Section 403(b) contracts; that is, assuming that those benefits satisfy the incidental benefit rule under Treasury Regulation Section 1.403(b)-6(g). The special rule for life insurance contracts does not apply to a contract issued before September 24, 2007.<a href="#_ftn14" name="_ftnref14">14</a> Multiple contracts are considered a single contract for purposes of applying the 403(b) rules; consequently, separate insurance contracts may be purchased as part of a 403(b) annuity plan. These insurance contracts must meet the form requirements and all the limitations of an IRC Section 403(b) annuity contract. It does not appear to matter whether the form requirements and limitations are imposed by means of an endorsement to the insurance policy,<a href="#_ftn15" name="_ftnref15">15</a> an addendum to the salary reduction agreement,<a href="#_ftn16" name="_ftnref16">16</a> or a trust agreement.<a href="#_ftn17" name="_ftnref17">17</a> <hr> Planning Point: It should be noted, however, that most IRS rulings on this issue do not address whether such an insurance investment would be permissible if the amounts were invested in a custodial account. <hr> Where an insurance policy endorsement failed to adequately restrict the premiums to meet the incidental benefit limit and the elective deferral limit and also contained conflicting provisions that rendered the agreement revocable, the IRS ruled that the life policy as endorsed did not constitute a 403(b) annuity contract.<a href="#_ftn18" name="_ftnref18">18</a> The IRS has ruled privately that it is irrelevant whether the premiums under the insurance contract are paid by contributions made by the employer on behalf of the participant under a salary reduction agreement or by dividends and interest thereon accumulated under the contract so long as the incidental benefit limit is not exceeded.<a href="#_ftn19" name="_ftnref19">19</a> <hr> Planning Point: Revenue Ruling 90-24 has been revoked, and life insurance now cannot be purchased under a 403(b) plan. <hr> The life insurance protection contained in a retirement income or pension plan endowment type of policy comes within the incidental limitation. An endowment policy with an annuity rider that, when combined, provided in later policy years a death benefit greater than under a typical retirement income policy qualified as an annuity contract when actuarial comparison of only the endowment contract with the retirement income contract indicated the cost of the death benefit under the endowment contract was less than that of the retirement income contract.<a href="#_ftn20" name="_ftnref20">20</a> However, Treasury Regulation Section 1.403(b)–8(c)(2) does not permit a life insurance contract, an endowment contract, a health or accident insurance contract, or a property, casualty, or liability insurance contract to constitute an annuity contract for purposes of Section 403(b) if issued after September 23, 2007. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.403(b)-2(b)(2). <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 1.403(b)-8(d)(1). <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.403(b)-9(a). <a href="#_ftnref4" name="_ftn4">4</a>.  Let. Rul. 9422053. <a href="#_ftnref5" name="_ftn5">5</a>.  Rev. Rul. 68-116, 1968-1 CB 177. <a href="#_ftnref6" name="_ftn6">6</a>.  Rev. Proc. 99-44, 1999-48 IRB 598, modifying Rev. Rul. 81-225, 1981-2 CB 12. <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 401(g). See also Treas. Reg. § 1.401-9(a). <a href="#_ftnref8" name="_ftn8">8</a>.  Treas. Reg. § 1.403(b)-8(d). <a href="#_ftnref9" name="_ftn9">9</a>.  IRC § 403(b)(7). <a href="#_ftnref10" name="_ftn10">10</a>.  Treas. Reg. § 1.403(b)-8(c)(3). <a href="#_ftnref11" name="_ftn11">11</a>.  Rev. Rul. 82-102, 1982-1 CB 62. See Corbin v. U.S., 760 F.2d 234 (8th Cir. 1985). <a href="#_ftnref12" name="_ftn12">12</a>.  Treas. Reg. §§ 1.403(b)-8(e), 1.403(b)-9(a). <a href="#_ftnref13" name="_ftn13">13</a>.  Treas. Reg. § 1.403(b)-8(c)(2); see also Treas. Reg. § 1.401(f)-4(e). <a href="#_ftnref14" name="_ftn14">14</a>.  Treas. Reg. § 1.403(b)-8(c)(2). See also Treas. Reg. § 1.403(b)-11(f). <a href="#_ftnref15" name="_ftn15">15</a>.  Let. Ruls. 9713022 (variable universal life policy), 9626042, 9336054, 9336053, 9327025, 9324042, 9303024. <a href="#_ftnref16" name="_ftn16">16</a>.  Let. Rul. 9324044. <a href="#_ftnref17" name="_ftn17">17</a>.  Let. Ruls. 9324043, 9106022. <a href="#_ftnref18" name="_ftn18">18</a>.  Let. Rul. 9242022. <a href="#_ftnref19" name="_ftn19">19</a>.  Let. Rul. 9215055. <a href="#_ftnref20" name="_ftn20">20</a>.  Rev. Rul. 74-115, 1974-1 CB 100. </div></div>