Amounts Not Received As An Annuity

<p>To give effect to the grandfathering of pre-August 14, 1982 annuities, a replacement contract obtained in a tax&ndash;free exchange of annuity contracts ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="570">570</a>) 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.<a href="#_ftn1" name="_ftnref1">¹</a> Investment in the replacement contract is considered made on, before, or after August13, 1982 to the same extent the investment was made on, before, or after August13, 1982 in the replaced contract.<br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. Rev. Rul. 85-159, 1985 CB 29.</p></p><br />

<p>A lifetime income benefit rider (LIBR), while similar to a guaranteed lifetime withdrawal benefit rider (GLWB, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="521">521</a>), is a rider pursuant to which the annuity carrier agrees to pay income over the taxpayer&rsquo;s lifetime in the form of an annuity. The income stream that results once the taxpayer annuitizes the contract is also drawn from the annuity&rsquo;s benefit base, but the carrier uses the taxpayer&rsquo;s life expectancy to determine the value of the guaranteed income payments. Taxpayers seeking out steady, level annuity payouts that are guaranteed regardless of how long they live are often attracted to this type of feature.<br /> <br /> One common ground between a LIBR and GLWB is the fact that the benefit base itself is not available for cash withdrawals. The benefit base is an &ldquo;account&rdquo; that has no real current cash value to the taxpayer&mdash;meaning that, unlike the accumulation value of the account, the taxpayer cannot access this value through surrendering the contract prior to the end of the deferral period.</p><br />

<p>The purpose behind the &ldquo;interest first&rdquo; rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="515">515</a>) 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.<br /> <br /> 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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="587">587</a>), annuity contract death benefits ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="591">591</a>), 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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="545">545</a>).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> For information on the effect of a tax-free exchange, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="518">518</a>.<br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. IRC &sect; 72(e)(5).</p></p><br />

<p>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 &ldquo;amount not received as an annuity&rdquo; unless the transfer is between spouses or incident to a divorce under the IRC Section 1041 non-recognition rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="106">106</a>). 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&rsquo;s investment in the contract will be increased by the amount, if any, included in income by the transferor ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="580">580</a>).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><strong>Planning Point:</strong><p> 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.<br /> <br /> </p><hr><hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. IRC &sect; 72(e)(4)(C).</p></p><br />

<p>A guaranteed lifetime withdrawal benefit rider (GLWB) guarantees that the taxpayer will be able to withdraw a certainpercentage of the value of the benefit base of the taxpayer&rsquo;s annuity, which has been growing by a guaranteed amount over the course of the deferral period (the guarantee is commonly somewhere between 4 and 8percent). Taxpayers looking for larger payouts later in life should be advised that the longer the base account is allowed to grow, the larger the withdrawals will be in the future. Further, it is important that the taxpayer understand that he or she must stay within the limits of the guaranteed withdrawals; some contracts provide for termination of the feature if the taxpayer takes an excess withdrawal.<br /> <br /> One common ground between these types of riders and a lifetime income benefit rider (LIBRs, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="522">522</a>) lies in the fact that the benefit base itself is not available for cash withdrawals. This &ldquo;account&rdquo; has no real current cash value to the taxpayer&mdash;meaning that, unlike the accumulation value of the account, the taxpayer cannot access this value through surrendering the contract prior to the end of the deferral period.</p><br />

<p>Dividends received before the annuity start date or the first date that an amount is received as an annuity, whichever is later, are subtracted from the consideration paid (i.e., the cost basis) of the annuity and are not taxable. If the investment in the contract is reduced all the way to $0, any further dividends received become taxable. Notably, the reduction in the investment in the contract as dividends are reduced applies both for determining the taxation of the dividends themselves, and also the investment in the contract for the purposes of determining the exclusion ratio if the contract is subsequently annuitized.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Dividends received after the annuity start date or the first date that an amount is received as an annuity, whichever is later, are included in full in the recipient&rsquo;s gross income. Contrary to the case where dividends were received prior to the annuity start date, the exclusion ratio (discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a>) is not affected by dividends received after the annuity start date. The exclusion ratio in place prior to payment of the dividend continues to apply.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. Treas. Reg. &sect; 1.72-11(b)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. &sect; 1.72-11(b)(2).</p></p><br />

<p>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 August13, 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).<a href="#_ftn1" name="_ftnref1">¹</a> 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 59&frac12; or the taxpayer&rsquo;s disability ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="523">523</a>).)<br /> <br /> For the purpose of determining the taxable portion of a partial surrender, cash surrender value is determined without regard to any surrender charge.<a href="#_ftn2" name="_ftnref2">²</a> This is not the case with regard to total surrenders ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="587">587</a>). 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.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Policy dividends, cash withdrawals, and amounts received on partial surrender under annuity contracts entered into before August14, 1982 (and allocable to investment in the contract made before August14, 1982) are taxed under the &ldquo;cost recovery rule.&rdquo; 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-August14, 1982 investment in the contract; the amounts are taxable only after such basis has been fully recovered.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> Amounts received that are allocable to an investment made after August13, 1982, in an annuity contract entered into before August14, 1982, are treated as received under a contract entered into after August13, 1982, and are subject to the &ldquo;interest first&rdquo; rule.<a href="#_ftn5" name="_ftnref5">⁵</a> If an annuity contract has income allocable to earnings on pre-August14, 1982 and post-August13, 1982 investments, the amount received is allocable first to investments in the contract made prior to August14, 1982, then to income accumulated with respect to such investments (under the &ldquo;cost recovery&rdquo; rule), then to income accumulated with respect to investments made after August13, 1982, and finally to contributions made after August13, 1982, under the &ldquo;interest-first&rdquo; rule.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> 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 advisor who would manage the taxpayer&rsquo;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&rsquo;s income to the extent allocable to the income on the contract.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> 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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="477">477</a>) 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.<a href="#_ftn8" name="_ftnref8">⁸</a> For more information on the tax treatment of other amounts received under an annuity contract before the annuity starting date, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="517">517</a>. For information on the effect of a tax-free exchange, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="518">518</a>.<br /> <br /> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="613">613</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4083">4083</a>. The rules applicable to loans under qualified plans and under tax sheltered annuity (IRC Section 403(b)) contracts are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3948">3948</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4058">4058</a>, respectively.<br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. IRC &sect; 72(e).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 72(e)(3).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 72(e)(4).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. IRC &sect; 72(e)(5).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. IRC &sect; 72(e)(5).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>. Rev. Rul. 85-159, 1985 CB 29.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>. Let. Rul. 9342053.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>. IRC &sect; 72(e)(11).</p></p><br />

<p>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 the amount of any distribution that is includable in income under the rules explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="515">515</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="519">519</a>.<a href="#_ftn1" name="_ftnref1">¹</a> An annuity that is received as part of an IRC Section 1035 exchange that was undertaken as part of a troubled insurer&rsquo;s rehabilitation process under Revenue Ruling 92-43 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="570">570</a>) 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 &ldquo;grandfathered&rdquo; back to the issue date of the original annuity for this purpose.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> This aggregation rule does not apply to distributions received under qualified pension or profit sharing plans, from an IRC Section403(b) contract, or from an IRA.<a href="#_ftn3" name="_ftnref3">³</a> The Conference Report on OBRA &rsquo;89 also states the aggregation rule does not apply to immediate annuities.<br /> <br /> If the contract is owned by a corporation or other non-natural person, see also Q <a href="javascript:void(0)" class="accordion-cross-reference" id="513">513</a>.<br /> <br /> For amounts received under life insurance or endowment contracts, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="10">10</a>. For distributions received under life insurance policies that are classified as modified endowment contracts, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="13">13</a>.<br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. IRC &sect; 72(e)(12).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Let. Rul. 9442030.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 72(e)(12)(A).</p></p><br />

<p>Taxation of dividends under an annuity contract depends on when the contract was purchased. If the contract was purchased after August 13, 1982, dividends received before the annuity starting date are taxable to the extent the cash value of the contract (determined without regard to any surrender charge) immediately before the dividend is received exceeds the investment in the contract at the same time. If there is no excess of cash value over the investment in the contract (i.e., no gain), further dividends are treated as a tax-free recovery of investment. If the annuity contract was purchased before August 14, 1982, and no additional investment was made in the contract after August 13, 1982, the dividends will be taxed in the same manner as dividends received under life insurance contracts (generally tax-free until basis has been recovered; see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="22">22</a>).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Dividends retained by the insurer as a premium, or other consideration for the contract, are not included in income.<a href="#_ftn2" name="_ftnref2">²</a> Dividends paid but left with the insurer to accumulate at interest would not be considered retained as premium or consideration.<br /> <br /> If any investment has been made after August13, 1982 in an annuity contract entered into before August14, 1982, dividends allocable to that investment are includable as dividends on a contract entered into after August13, 1982.<a href="#_ftn3" name="_ftnref3">³</a> Dividends received under an annuity contract with income allocable to earnings on pre-August14, 1982, and post-August13, 1982, investments are allocable first to investments made prior to August14, 1982, then to income accumulated with respect to such pre-August14, 1982 investments, then to income accumulated with respect to investments made after August13, 1982, and finally to investments made after August13, 1982.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> Dividends received after the annuity starting date ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="536">536</a>) are included in gross income regardless of when the contract was entered into or when any investment was made.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> A special exception applies to annuity contracts purchased by a qualified pension, profit sharing or stock bonus plan, an individual retirement account or annuity, or a special plan of a life insurance company for its employees, or purchased as an IRC Section 403(b) tax sheltered annuity ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3963">3963</a>).<br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. IRC &sect; 72(e).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 72(e)(4)(B).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 72(e)(5).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. Rev. Rul. 85-159, 1985 CB 29.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. IRC &sect; 72(e)(2)(A).</p></p><br />

<p>Payments excepted from the 10 percent penalty ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="523">523</a>) by reason of the substantially equal periodic payment exception may be subject to recapture if the series of payments is modified, other than by reason of death or disability, prior to the taxpayer&rsquo;s reaching age 59&frac12; or, if later, before the end of a five-year period beginning on the date of the first payment (even if the taxpayer has reached age 59&frac12;).<br /> <br /> According to the report of the Conference Committee, the modification that triggers recapture is a change to a method of distribution that would not qualify for the exemption. The tax on the amount recaptured is imposed in the first taxable year of the modification and is equal to the tax as determined under regulations that would have been imposed, plus interest, retroactively back to the first such distribution made had the exception never applied.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> The IRS announced that the three methods used to avoid the 10 percent penalty when making substantially equal periodic payments from a qualified retirement plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3679">3679</a>) also may be used to qualify as substantially equal periodic payments from a nonqualified annuity. The &ldquo;one time election&rdquo; to change methods also may be used by owners of nonqualified annuities. Finally, there will be no penalty if an individual depletes an account by using one of the approved methods.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. H.R. Conf. Rep. No.99-841 (TRA &rsquo;86) reprinted in 1986-3 CB Vol. 4 403.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Notice 2004-15, 2004-9 IRB 526.</p></p><br />