Variable Annuities

<div class="Section1">A PPVA investment is an annuity that is available only to high net worth individuals who qualify as accredited investors (and, practically, qualified purchasers), meaning that they meet certain requirements as to net worth and investment sophistication. It is an annuity in that it is treated as such for tax purposes, but the similarities to the traditional retail annuities that most taxpayers associate with the term ends there—PPVA investments do not offer the types of income guarantee riders and protection against market risks that today’s retail annuities typically make available.</div><br /> <div class="Section1"><br /> <br /> Instead, the draw of the PPVA investment is the investment flexibility and tax-deferred growth that these types of accounts offer. The taxpayer has the freedom to made additional deposits to the annuity and change his or her investment allocations based on a number of investment options—typically, these annuities will provide a choice of investments that includes non-traditional investment options, such as hedge fund and private equity investments that have the potential to generate substantial returns.<br /> <br /> Taxes on the account growth are deferred until the taxpayer begins taking annuity payouts (a 10 percent penalty charge applies if distributions begin before the taxpayer reaches age 59½). In order to qualify for this favorable tax treatment, the PPVA investment must offer only investment options that are available solely to qualified insurance companies.<br /> <br /> Further, the underlying asset allocations must meet certain investment diversification requirements—for example, no more than 55 percent of the individual’s assets may be allocated to any single investment and no more than 70 percent may be allocated to any two investments. The taxpayer has control over his or her investment allocations, but cannot have control over the investment <em>choices</em> that are offered within the PPVA investment—an independent investment manager must have discretion to choose the investments that will be made available to the taxpayer.<br /> <br /> </div>

<div class="Section1">The regulations answer this question by their focus: only QLACs are addressed within the regulations. IRA-held DIAs that are not QLACs are not governed by the new regulations. These regulations are additive in that they do not remove any of the previously existing rules that govern these types of annuity contracts. As a result, the regulations do not prevent a taxpayer from holding a non-QLAC DIA in a traditional IRA. In such a case, the previously existing method for determining RMDs for non-QLAC DIAs will apply.</div><br /> <div class="Section1"><br /> <br /> The actuarial present value [APV] (which may be referred to as fair market value [FMV]) is calculated and RMDs attributable to that value must be withdrawn from another IRA or through a commutation liquidation from the DIA contract itself. After the annuity starting date, the income payments from the DIA automatically satisfy the RMD requirement. No separate calculation is required.<br /> <br /> </div>

<div class="Section1">If an <em>irrevocable</em> grantor trust owns a deferred annuity and the grantor of the trust is not the annuitant, it is not clear whether payment of death proceeds will be triggered upon the death of the grantor or upon the death of the annuitant. The Code provides that the primary annuitant will be considered the “holder” of the contract if the owner is a non-natural person (e.g., a trust).<a href="#_ftn1" name="_ftnref1">¹</a> Therefore, many experts argue that it is the death of the primary annuitant that triggers annuity payout.</div><br /> <div class="Section1"><br /> <br /> Others disagree, and argue that it is the grantor’s death that will trigger payout. This is because of the grantor trust rules, which treat the grantor of a trust and the trust itself as one individual for income tax purposes. Because the grantor is the owner of the trust assets for income tax purposes, many experts argue that the grantor should be treated as owner—or “holder”—for purposes of IRC Section 72(s). That said, this ambiguity applies only to deferred annuities owned by <em>irrevocable grantor</em> trusts. When the owner is a <em>revocable</em> trust, the grantor trust rules control (as the grantor is the “holder” for income tax purposes). Although that is also true when the trust is irrevocable and also a grantor trust, some authorities insist that the rule of IRC Section 72(s)(6)(A) controls, as the grantor of an irrevocable trust owning a deferred annuity does not have the unfettered control of that annuity contract that he would have were the trust revocable.<br /> <br /> At this point, the matter remains unresolved without any clarity or on-point guidance from the IRS.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 72(s)(6)(A)..<br /> <br /> </div>

<div class="Section1">Yes. Insurance carriers have begun offering optional riders that can be attached to variable deferred annuity products in order to include the benefits of a deferred income (“longevity”) annuity within the variable annuity. These deferred income annuities allow the contract owner to withdraw portions of the variable annuity itself in order to fund annuity payouts late into retirement.</div><br /> <div class="Section1"><br /> <br /> Taxpayers must purchase the rider at the time the variable annuity is purchased and can then begin transferring a portion of the variable annuity accumulation into the deferred income component as soon as two years after the contract is purchased. When the taxpayer begins making transfers into the deferred component, he or she must also choose the beginning date for the deferred payments.<br /> <br /> The deferral period can be as brief as two years or, in some cases, as long as 40 years, giving taxpayers substantial flexibility in designing the product to meet their individual financial needs. Further, taxpayers can choose to transfer as little as around $1,000 at a time or as much as $100,000 to build the deferred income portion more quickly.<br /> <br /> The deferred income annuity rider can simplify taxpayers’ retirement income planning strategies in several important ways, not the least of which involves the ability to gain the benefits of both variable deferred and deferred income annuities within one single annuity package.<br /> <br /> This single-package treatment also allows taxpayers to avoid the situation where they wish to transition their planning strategies to eliminate the investment-type features common to variable annuity products into a product that allows for a definite income stream—a situation that commonly arises around the time when a taxpayer retires.<br /> <br /> Without the combination product, the taxpayer would traditionally be required to execute a tax-free exchange of the variable annuity contract for a deferred income annuity. Instead, the deferred income annuity rider allows the taxpayer to systematically transfer funds from the variable portion of the contract into the deferred income portion over time (though lump sum transfers are also permissible).<br /> <br /> </div>

<div class="Section1">A deferred annuity provides for an initial waiting period before the contract can be annuitized (usually between one and five years), and during that period the contract’s cash value generally remains liquid and available (albeit potentially subject to surrender charges). Beyond the initial waiting period the contract <em>may </em>be annuitized, though the choice remains in the hands of the annuity policyowner, at least until the contract’s maximum maturity age (at which point it must be annuitized).</div><br /> <div class="Section1"><br /> <br /> By contrast, a longevity annuity generally provides no access to the funds during the deferral period, and does not <em>allow </em>the contract to be annuitized until the owner reaches a certain age (usually around 85).<br /> <br /> In other words, many taxpayers purchase traditional deferred annuity products with a view toward waiting until old age to begin annuity payouts, but they always have the option of beginning payouts at an earlier date. With a longevity annuity, there is generally no choice, but this also allows for larger payments for those who do survive to the starting period; as a result, for those who survive, longevity annuities typically provide for a larger payout (often, much larger) than traditional deferred annuity products.<br /> <br /> Most taxpayers who purchase longevity annuities do so in order to insure against the risk of outliving their traditional retirement assets. The longevity annuity, therefore, functions as a type of safety net for expenses incurred during advanced age. Where a deferred annuity contract may be more appropriately categorized as an investment product, the primary benefit of a longevity annuity is its insurance value.<br /> <br /> </div>

<div class="Section1">A qualified longevity annuity contract (QLAC, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="556">556</a>) may be held in a qualified defined contribution plan (such as a 401(k) plan), IRC Section&nbsp;403 plans, traditional IRAs and individual retirement annuities under Section&nbsp;408, and eligible IRC Section&nbsp;457 governmental plans.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> An annuity purchased within a Roth IRA cannot quality as a QLAC. If a QLAC is purchased under a traditional IRA or qualified plan that is later rolled over or converted to a Roth IRA, the annuity will not be treated as a QLAC after the date of the rollover or conversion.<a href="#_ftn2" name="_ftnref2">²</a> While it is true that an annuity purchased in a Roth IRA cannot qualify as a QLAC, it should not be assumed that a Roth IRA cannot purchase a longevity annuity. The final regulations do not prohibit this.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.401(a)(9)-6, A-17(b)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.401(a)(9)-6, A-17(d)(3)(ii).<br /> <br /> </div></div><br />

<div class="Section1">The Treasury Department answers this question by implication in revised Treasury Regulation Section 1.401(a)(9)-6, A-17(c)(v), which states that, for contracts permitting a set non-spousal beneficiary designation, “payments are payable to the beneficiary only if the beneficiary was irrevocably designated on or before the later of the date of purchase or the employee’s required beginning date.” Based upon this language, it is clear that an employee (in the case of a qualified plan) or IRA participant may purchase a QLAC after his or her RBD.<br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> The final regulations do not answer the following question: Can a QLAC in a qualified plan be converted to a traditional IRA?<br /> <br /> <hr /><br /> <br /> At this point in time, the answer to this question may depend upon the insurers’ administrative systems.<br /> <br /> </div>

<div class="Section1">IRS Notice 2014-66 specifically permits 401(k) plan sponsors to include deferred annuities within TDFs without violating the nondiscrimination rules that otherwise apply to investment options offered within a 401(k). This is the case even if the TDF investment is a qualified default investment alternative (QDIA)—which is a 401(k) investment that is selected automatically for a plan participant who fails to make his or her own investment allocations.</div><br /> <div class="Section1"><br /> <br /> Further, the guidance clarifies that the TDFs offered within the plan can include deferred annuities even if some of the TDFs are only available to older participants—even if those older participants are considered “highly compensated”—without violating the otherwise applicable nondiscrimination rules. Similarly, the nondiscrimination rules will not be violated if the prices of the deferred annuities offered within the TDF vary based on the participant’s age.<br /> <br /> The IRS guidance will allow plan sponsors to include annuities within TDFs even if a wide age variance exists among the plan’s participants. Additionally, the rules allow plan sponsors to provide a participant with guaranteed lifetime income sources even if the participant is not actively making his or her own investment decisions with respect to plan contributions—a situation which is increasingly prevalent as employers may now automatically enroll an employee in the 401(k) plan unless the employee actively opts out of participation.<br /> <br /> </div>

<div class="Section1">If the annuitant’s annuity starting date is after July 1, 1986, a deduction may be taken on the individual’s final income tax return for the unrecovered investment in the contract remaining on the date of death.<a href="#_ftn1" name="_ftnref1">¹</a> Similarly, a refund beneficiary may deduct any unrecovered investment in the contract that exceeds the refund payment.<a href="#_ftn2" name="_ftnref2">²</a> For purposes of determining if the individual has a net operating loss, the deduction is treated as if it were attributable to a trade or business.<a href="#_ftn3" name="_ftnref3">³</a></div><br /> <div class="Section1"><br /> <br /> If an annuitant’s annuity starting date was before July 2, 1986, there is no deductible loss; the view under the law at the time was that the annuitant had received all that the contract required.<a href="#_ftn4" name="_ftnref4">⁴</a> For example, no loss deduction was allowed where a husband purchased a single premium nonrefundable annuity on the life of his wife and his wife died before his cost had been recovered. The deduction was disallowed on the ground that the transaction was not entered into for profit.<a href="#_ftn5" name="_ftnref5">⁵</a> Legislatively, the denial of a deductible loss for unrecovered investment at death was viewed as a trade-off for the fact that exclusion ratio non-taxable payments also could continue beyond the point of fully recovering cost basis for contracts before July 2, 1986.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 72(b)(3)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 72(b)(3)(B).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 72(b)(3)(C).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     <em>Industrial Trust Co. v. Broderick</em>, 94 F.2d 927 (1st Cir. 1938); Rev. Rul. 72-193, 1972-1 CB 58.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     <em>White v. U.S.</em>, 19 AFTR 2d 658 (N.D. Tex. 1966).<br /> <br /> </div>

<div class="Section1">Both fixed dollar and variable annuity payments received as an annuitized stream of income are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser&rsquo;s investment, and the balance is taxable as ordinary income. In the case of a variable annuity, however, the excludable portion is not determined by calculating an &ldquo;exclusion ratio&rdquo; as it is for a fixed dollar annuity ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a>). Because the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. Thus, the excludable portion of each payment is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid.<a href="#_ftn1" name="_ftnref1">¹</a> In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.<div class="Section1"><br /> <br /> If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If payments are to be made for a single life, the divisor is the appropriate life expectancy multiple from Table I or Table V, whichever is applicable (depending on when the investment in the contract was made). If payments are to be made on a joint and survivor basis, based on the same number of units throughout both lifetimes, the divisor is the appropriate joint and survivor multiple from Table II or Table&nbsp;VI, whichever is applicable (depending on when the investment in the contract is made). IRS regulations explain the method for computing the exclusion where the number of units is to be reduced after the first death. The life expectancy multiple need not be adjusted if payments are monthly. If they are to be made less frequently (annually, semi-annually, quarterly), the multiple must be adjusted.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A portion of each payment is only excluded from gross income using the exclusion ratio until the investment in the contract is recovered (normally, at life expectancy).<a href="#_ftn3" name="_ftnref3">³</a> However, if payments received are from an annuity with a starting date that was before January&nbsp;1, 1987, payments continue to receive exclusion ratio treatment for life, even if the total cost basis recovered exceeds the original investment amount.<br /> <br /> Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of the year&rsquo;s exclusion.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> If an annuity settlement provides a period-certain or refund guarantee, the investment in the contract must be adjusted before being prorated over the payment period ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="551">551</a>).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.72-2(b)(3).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&sect; 1.72-2(b)(3), 1.72-4(d).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(b)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.72-2(b)(3).<br /> <br /> </div></div><br />