Taxation of annuities.
Cash Value Build-Up. Provided the annuity contract meets the requirements of Internal Revenue Code Section 72 and a "natural person" owns the annuity, the interest or other earnings on the funds inside the annuity contract will not be currently taxed. However, if the owner is a corporation, or other entity that is not a natural person, the earnings on contributions made after February 28, 1986 are subject to current taxation. One broad exception to this rule is when an annuity is held by a trust, corporation, or other "nonnatural" person as an agent for a natural person, in which case the annuity is not subject to current taxation. There are additional exceptions to this nonnatural person rule with other types of annuities.
Withdrawals. The taxation of withdrawals from or partial surrenders of an annuity depends upon the date that the annuity contract was first entered into:
(1) Entered into after August 13, 1982. Amounts received are taxed under the "interest first rule," meaning that they are taxable to the extent that the cash value of the contract exceeds the investment in the contract (i.e., treated as distributions of interest first and thereafter as recovery of cost).
(2) Entered into on or before August 13, 1982. Amounts received are taxed under the "cost recovery rule," meaning that they are not taxable to the extent of the annuity owner's investment in the contract made on or before August 13, 1982 (i.e., treated as recovery of pre-August 14, 1982 cost and thereafter as distributions of taxable interest).
Different rules apply to amounts received under qualified retirement plans, Section 403(b) annuities, and Individual Retirement Arrangements.
Premature Distribution Penalty Tax. Subject to certain exceptions, any distribution from an annuity prior to the taxpayer (payee) having reached age 59VS is subject to a 10-percent-penalty tax on the taxable portion of the annuity payment.6 For example, assume that the annuity holder purchased an annuity for $25,000 and thereafter surrendered it at age 55 for $32,000. The amount subject to both ordinary income taxes and the 10-percent-penalty tax is the gain of $7,000 (32,000 - 25,000 = 7,000). One exception commonly used to avoid this 10-percent-penalty tax allows for penalty-free payments to a taxpayer of any age, provided they are part of a "series of substantially equal periodic payments" that are made at least annually for the life of the taxpayer, or for the joint lives or joint life expectancies of the taxpayer and a designated beneficiary (e.g., a joint and survivor annuity). However, payments not subject to the 10% penalty by reason of this exception may be subject to recapture if the series of payments is modified (other than by reason of death or disability).
Benefit Payments. The basic rule governing the income taxation of payments received from an annuity contract is designed to return the purchaser's investment in equal tax-free amounts over the annuity's payment period. The balance of each payment must be included in income. Therefore, each payment is generally part nontaxable return of cost and part taxable income.
(1) Expected Return. To calculate the annuity's exclusion ratio, the expected return is divided into the investment in the contract. if payments are for a fixed period or fixed amount with no life expectancy involved, the expected return is equal to the sum of the guaranteed payments. If payments are to continue for one life or multiple lives, the expected return is determined 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 are obtained from a series of Annuity Tables provided by the IRS. Gender-based tables (I, II, IIA, and III) are generally used if the investment in the contract does not include a post-June 30, 1986, investment. Unisex tables (V, VI, VIA and VII) are generally used if the investment in the contract includes a post-June 30, 1986, investment in the contract. (7) The following summarizes these tables.
(2) Exclusion Ratio With Fixed Return. This ratio identifies the portion of the annuity payment that is not taxed (i.e., that portion representing the purchaser's basis in the contract). It is expressed as a fraction, or as a percentage, and is determined by dividing the investment in the contract by the expected return. For example, assume that a contract holder purchases an annuity for $100,000 and elects an annuity certain paying $1,200 per month for 10 years. The expected return for a fixed period or fixed amount with no life expectancy involved is the sum of the guaranteed payments, or $144,000 (1,200 x 12 x 10 = 144,000). The exclusion ratio is 69.4%. (It is rounded to the nearest tenth of a percent.)
Exclusion Ratio = Investment In Contract/Expected Return
Exclusion Ratio = 100,000/144,000 = 69.4%
This means that 69.4%, or $833, of every monthly payment may be excluded from income (1,200 x .694 = 833). The balance of $367 is included in income (1,200 - 833 = 367).
(3) Exclusion Ratio With Life Expectancy. Now assume that the contract holder is age 58, purchases an annuity for $100,000, and elects to receive a life annuity paying $700 per month for life (i.e., a single life "pure" annuity). The expected return is determined by multiplying the $700 monthly payment by 12 to arrive at the yearly payment of $8,400, and then multiplying this amount by the contract holder's life expectancy (25.9 years) obtained from the unisex Table V (Ordinary Life Annuities--One Life--Expected Return Multiples). (8) The expected return is $217,560 (700 x 12 x 25.9 = 217,560). The exclusion ratio is 46.0[degrees]%.
Exclusion Ratio = Investment In Contract/Expected Return
Exclusion Ratio = 100,000/217,560 = 46.0%
This means that 46.0% ($322) of every monthly payment may be excluded from income (700 x .460 = 322). The balance of $378 is included in income (700 - 322 = 378). The yearly amount of taxable income is $4,536 (378 x 12 = 4,536). However, if the annuity starting date is after December 31, 1986, this exclusion ratio applies to payments received until the investment in the contract is fully recovered. Once the cost has been recovered, all payments are fully includable in income (i.e., the exclusion ratio no longer applies once the annuitant reaches his or her life expectancy). In this example, the contract holder is fully taxed on the monthly payment of $700 after 311 months of payments are received (100,000 / 322 = 311).
(4) Exclusion Ratio With Guaranteed Payments. Assume that the contract holder is age 58, and purchases an annuity for $100,000, electing to receive a life annuity paying $550 per month for life with payments guaranteed for 20 years (i.e., a single life 20-year-period-certain annuity). The expected return is determined by multiplying the $550 monthly payment by 12 to arrive at the yearly payment of $6,600, and then multiplying this amount by the contract holder's life expectancy (25.9 years) obtained from the unisex Table V (Ordinary Life Annuities--One Life--Expected Return Multiples). The expected return is $170,940 (550 x 12 x 25.9 = 170,940).
Before calculating the exclusion ratio, the investment in the contract ($100,000) must be reduced to account for the value of the guarantee. The percent value of the guaranteed refund is 9% (from Table VII for age 58 and 20 years). This is multiplied by the lesser of the unadjusted investment in the contract ($100,000) or the guaranteed return ($132,000) to determine the value of the refund feature ($9,000). The value of the refund feature is then subtracted from unadjusted investment in the contract to determine the adjusted investment in the contract ($91,000). The exclusion ratio is 53.2%.
Exclusion Ratio = Investment In Contract/Expected Return
Exclusion Ratio = 91,000/170,940 = 53.2%
This means that 53.2% ($293) of every monthly payment may be excluded from income (550 x .532 = 293). The balance of $257 is included in income (550 - 293 = 257). The yearly amount of taxable income is $3,084 (257 x 12 = 3,084). As in the example in paragraph (3) above, if the annuity starting date is after December 31, 1986, once the investment in the contract has been recovered all payments are fully includable in income.
Estate Taxation Of Annuities. The estate taxation of an annuity will typically differ depending upon whether the annuity is in the accumulation phase or distribution phase (page 424).
(1) Accumulation Phase. The value of an annuity must generally be included in the annuity owner's gross estate. (If the decedent furnished only part of the annuity's purchase price, the decedent's gross estate includes only a proportional share of the annuity's value.)
(a) Owner is also the annuitant. The value of the annuity death benefit is included in the owner's estate.
(b) Owner is not the annuitant. If the owner dies first, then the value included in the owner's estate is apparently the amount that it would cost to purchase a comparable annuity contract. If the annuitant dies first, the annuity death benefit is generally not included in the gross estate of the annuitant, but it is a taxable gift from the surviving annuity owner to the beneficiary.
(2) Distribution Phase. The following assumes that the "annuity holder" is both the owner and the annuitant. If payments were made under a straight life annuity, payments cease upon the annuity holder's death; there is no remaining property interest, nothing is passed to survivors, and nothing is included in the annuity holder's estate. However, the value of any survivor benefits is included in the annuity holder's estate (e.g., benefits passing under a refund annuity, a joint and survivor annuity, a fixed period annuity, and a fixed amount annuity). Benefits passing to a surviving spouse generally qualify for the marital deduction, and therefore are not subject to estate taxes.
Gift Taxation Of Annuities. If an individual purchases an annuity, names himself as the annuitant, and immediately gives the annuity contract to another person, the value of the gift is considered to be the amount of premium paid for the annuity. However, if the contract is held for a period of time after it is purchased, then the gift tax value is the single premium that the life insurance company would charge for an annuity providing the same benefits on the life of a person who is the same age as the annuitant when the gift is made. These gifts will not be subject to gift taxes if they are less than the annual exclusion amount of $13,000 in 2010 (see Present Interest Gifts, page 467). Future premiums paid on the annuity will also qualify for the annual exclusion. Likewise, an individual who pays premiums on an annuity contract owned by another individual is considered to make a gift of the premium amounts.
Expected Return Multiples Gender Based Table I Ordinary Life Annuities One Life Table II Ordinary Joint Life and Last Survivor Two Lives Annuities Table IIA Annuities for Joint Life Only Two Lives Unisex Table V Ordinary Life Annuities One Life Table VI Ordinary Joint Life and Last Survivor Two Lives Annuities Table VIA Annuities for Joint Life Only Two Lives Percent Value of Refund Feature Table III Gender Based Table VII Unisex These tables can be found in Appendix A of Tax Facts on Insurance & Employee Benefits, published annually by The National Underwriter Company.
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|Title Annotation:||Chapter 17: planning for retirement|
|Author:||Cady, Donald F.|
|Publication:||Field Guide to Financial Planning|
|Date:||Jan 1, 2010|
|Previous Article:||Private annuity.|
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