Annuities & Taxes

TaxFactsOnline for Life Health Pro writes: Q: What is an annuity contract and what general rules govern the income taxation of payments received under annuity contracts?

 An annuity contract is a financial instrument where a premium is paid to a company (or in some cases to an individual) in return for a promise to pay a certain amount for either a specific period of time or over a person’s lifetime. There are different variations of this basic form. An immediate annuity contract is one in which regular annuity payments will commence within one year. A deferred annuity contract is one in which the annuity start date (i.e., the date when regular annuity income payments begin) is deferred until the contract’s owner elects to start payments; payments can be deferred for many years, and in today’s world many annuity owners simply maintain the contract in deferred status. Nonqualified annuities are annuities that are not held within a “qualified” retirement plan or an IRA.

The rules in IRC Section 72 govern the income taxation of all amounts received under nonqualified annuity contracts. IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns. Qualified annuity contracts are governed by the tax rules of the retirement account in which they are held.

The term “annuity” includes all periodic payments resulting from the systematic liquidation of a principal sum and refers not only to payments for a life or lives, but also to installment payments that do not involve life contingency, such as payments under a “fixed period” or a “fixed amount” settlement option.

All “amounts received” under an annuity contract are either “amounts received as an annuity” or “amounts not received as an annuity.”

“Amounts received as an annuity” (annuity payments) are taxed under the annuity rules in IRC Section 72. These rules determine what portion of each payment is excludable from gross income as a return of the purchaser’s investment and what portion is taxed as interest earned on the investment. They apply to life income and other types of installment payments received under both immediate annuity contracts, and deferred annuity contracts that have been annuitized.

Payments consisting of interest only are not annuity payments and thus are not taxed as “amounts received as an annuity.” Periodic payments on a principal amount that will be returned intact on demand are interest payments. Such payments, and all amounts taxable under IRC Section 72 other than regular annuity payments, are classed as “amounts not received as an annuity.” These include amounts actually received as policy dividends, lump sum cash settlements of cash surrender values, cash withdrawals and amounts received on partial surrender, death benefits under annuity contracts, a guaranteed refund under a refund life annuity settlement, and policy loans, as well as amounts received by imputation (annuity cash value pledged as collateral for a loan). “Amounts not received as an annuity” are taxable under general rules.

Except in the case of certain annuity contracts held by nonnatural persons, income credited on a deferred annuity contract is not currently includable in a taxpayer’s income. There is no specific IRC section granting this “tax deferral.” Instead, it is granted by implication. The increase in cash value of an annuity contract, other than by application of dividends, is neither an “amount received as an annuity” nor an “amount not received as an annuity.” As a result, an increase in cash value is not a distribution and is not includable in the taxpayer’s income, except where the IRC specifically provides otherwise.

IRC Section 72 places a penalty on “premature distributions.”
Contracts issued after January 18, 1985 have post-death distribution requirements. These post-death distribution requirements also apply to contributions made after January 18, 1985, to contracts that were issued before that date. Contracts issued before January 18, 1985, with contributions that were made before that date are not subject to post-death distribution requirements.
The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of life insurance death proceeds. However, the rules for taxing such payments are similar to the IRC Section 72 annuity rules. On the other hand, as noted earlier, death proceeds under an annuity contract (i.e., from some form of guaranteed death benefit) are taxed as amounts not received as an annuity.
Employee annuities, under both qualified and nonqualified plans, and periodic payments from qualified pension and profit sharing trusts are taxable under IRC Section 72, but because a number of special rules apply to these payments, they are treated separately.
Annuity with long-term care rider. Under the Pension Protection Act of 2006, qualified long term care insurance can be provided as a rider to an annuity contract, beginning after December 31, 2009.

Q: How are payments under a variable immediate annuity taxed?

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’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 “exclusion ratio” as it is for a fixed dollar annuity. 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. In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.
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 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.
The amount so determined may be excluded from gross income each year for as long as the payments are received if the annuity starting date is before January 1, 1987 (even after the annuitant has outlived his or her life expectancy and has recovered his or her cost tax-free). In the case of an annuity starting date after 1986, the amount determined may be excluded from gross income only until the investment in the contract is recovered. 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’s exclusion.
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. What are the estate tax results when a decedent has been receiving payments under an annuity contract?

If a decedent was receiving a straight life annuity, there is no property interest remaining at the decedent’s death to be included in the decedent’s gross estate.
If a contract provides a survivor benefit (as under a refund life annuity, joint and survivor annuity, or installment option), tax results depend on whether the survivor benefit is payable to a decedent’s estate or to a named beneficiary and, if payable to a named beneficiary, on who paid for the contract.
If payable to a decedent’s estate, the value of the post-death payment or payments is includable in the decedent’s gross estate under IRC Section 2033 as a property interest owned by the decedent at the time of his or her death. If payable to a named beneficiary, the provisions of IRC Section 2039(a) and IRC Section 2039(b) generally apply and inclusion in the gross estate is determined by a premium payment test. Thus, if a decedent purchased the contract (after March 3, 1931), the value of the refund or survivor benefit is includable in the decedent’s gross estate.
In the event a decedent furnished only part of the purchase price, the decedent’s gross estate includes only a proportional share of this value.
The foregoing rules do not apply to death proceeds of life insurance on the life of a decedent. In addition, special statutory provisions apply to employee annuities under qualified pension and profit-sharing plans, to certain other employee annuities and to individual retirement plans.