Advanced planning

Taxation of deferred annuities

The taxation of deferred annuities has been changed so often that a single annuity contract could be subject to multiple tax rules depending upon the timing of the investments in the contract. A chronological list of the various rules that apply to annuities will be used to help understand the complexity of the taxation of annuities and, in particular, the taxation of distributions prior to the annuity starting date. In most cases, the applicability of a rule or set of rules depends on the date of the contribution to the annuity contract.

Investments prior to Aug. 14, 1982

For amounts allocable to investments in annuities prior to Aug. 14, 1982, any withdrawal from the contract which is not an annuity payment is treated as a return on the investment in the contract, first, and taxable as ordinary income only after the investment has been completely withdrawn. The owner could also take a loan against the cash value of the contract and the loan would not be treated as a withdrawal. No income tax penalties are imposed on premature distributions.

Investments between Aug. 14, 1982 and Jan. 18, 1985

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) modified the taxation of distributions from annuity contracts by replacing the first-in, first-out (FIFO) rule, which allowed tax-free distributions of periodic payments up to the amount of the investment in the contract, with a last-in, first-out (LIFO) rule which treats any periodic withdrawal as a distribution of earnings first and then a return of the investment in the contract only after all the earnings have been withdrawn.

TEFRA also required that loans be treated as distributions subject to LIFO treatment for investments made on or after Aug. 14, 1982. Immediate annuities were not affected by these tax law changes.

In addition to reversing the status of periodic withdrawals from annuity contracts, TEFRA also imposed a 5% penalty on the taxable portion of any distribution from an annuity except for distributions:

1. made on or after the taxpayer attains age 59 ½,
2. made on account of death or disability of the taxpayer,
3. which are part of a series of substantially equal periodic payments made for the life of the taxpayer or over a period extending for at least 60 months after the annuity starting date,
4. made from a qualified plan, or
5. allocable to investments made in the contract prior to Aug. 14, 1982.

Investments in contracts Issued after Jan. 18, 1985

Under TEFRA, the 5% penalty was applicable only to taxable amounts allocable to investments in the annuity contract made during the 10-year period immediately preceding the date of the distribution. Because of the complexity of tracing amounts allocable to investments made within 10 years prior to a particular withdrawal, the 10-yearaging provision was repealed by the Tax Reform Act of 1984. The repeal is effective for contracts issued after Jan. 18, 1985. Therefore, for any contracts issued prior to Jan. 19, 1985, premature distributions allocable to investments in the contract made after Aug. 13, 1982, are subject to a penalty if the 10-year aging is not satisfied. Premature distributions from contracts issued after Jan. 18, 1985, are subject to the penalty regardless of how much time has elapsed since the investment in the contract, unless one of the exceptions is satisfied.

Investments in contracts after Feb. 28, 1986

Annuity contracts which are owned by corporations and other non-natural entities are taxed according to the provisions of Internal Revenue Code Section 72(u). This code section states that gain on such an annuity contract is treated as ordinary income in the year it is credited to the contract. In other words, the inside build-up, or gain, is not deferred each year, but is subject to income taxes each year as it is earned. The change in the tax law affects annuities issued after Feb. 28, 1986, or contributions into existing annuity contracts which are made after the 1986 effective date.

There are several exceptions to the income tax treatment of annuities held by non-natural entities. The rule does not apply to any annuity contract which is:

1. acquired by the estate of a decedent by reason of the death of the decedent,
2. held under a qualified pension, profit sharing, or stock bonus plan, as a 403(b) tax-sheltered annuity, or under an individual retirement plan,
3. a qualified funding asset (as defined in Section 130(d), but without regard to whether there is a qualified assignment,
4. purchased by an employer upon the termination of a qualified plan and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or the employee’s beneficiary, or
5. an immediate annuity.

The tax code specifically states that if an annuity is held by a trust or other entity as an agent for a natural person, then the annuity is considered to be held by a natural person. As such, the inside build-up of gain will not be subject to tax each year. What the Code doesn’t clearly explain is what is meant by holding an annuity as an agent for a natural person. While there are several Private Letter Rulings indicating the IRS thinking on the matter, those only apply to the particular case. There are no regulations or authoritative rulings on what constitutes “an agent for a natural person.”

Trust ownership

The uncertainty in this area typically arises when irrevocable trusts own annuity contracts. The resolution of this issue depends on what type of trust you are dealing with in a particular situation.

There is very little authority in the form of regulations or rulings covering this subject. The few Private Letter Rulings that have been published seem to take a rather strict and literal reading of the code section. The critical issue boils down to whether the annuity contract is traceable to a single beneficiary to use for his/her retirement. If a trust has only one beneficiary, then the trust is merely a nominal owner and the individual is the beneficial owner of the contract. If the individual is considered to be the beneficial owner of the annuity contact, then the rules of Section 72(u) do not apply. Examples of this type of trust situation would include revocable living trusts and grantor trusts.

Where there are multiple trust beneficiaries, but only one annuity contract owned by the trust, it appears that the contract is being pooled for the use of multiple beneficiaries. This is problematic because the purpose behind the gain deferral is that the annuity is only available for a single person’s retirement.

Corporate ownership

The rules of Section 72(u) also apply to annuities owned by corporations. The most common issue surrounds the tax treatment of annuities owned by a corporation as part of a deferred compensation plan. Deferred compensation plans require the corporation to own the funding vehicle, and as such, the corporate annuity would be subject to the rules of Section 72(u). Since a corporate-owned annuity would be taxed on any gain each year, the tax consequences make it more expensive to use an annuity as the funding vehicle in a deferred compensation plan.

Contracts issued after April 22, 1987

The Tax Reform act of 1986 also modified the rule regarding the income tax treatment of gratuitous transfers of annuity contracts. Under prior law, the gift of an annuity contract did not result in recognition of gain. However, the Service had taken the position that if the donee subsequently surrenders the contract, the donor must recognize gain to the extent of any gain in the contract at the time of the gift. If a contract issued after April 22, 1987, is transferred for less than full and adequate consideration, the transferor is treated as receiving an amount equal to the gain in the contract as an amount not received as an annuity, meaning that the taxation on gain is not deferred. That amount would be included as ordinary income and would be subject to the penalty if it is a premature distribution. This rule does not apply to transfers between spouses.

The recipient of the contract would increase his/her other investment in the contract by the amount included in the transferor’s income so that the investment in the contract for purposes of determining gain would normally equal the cash value of the contract at the time of transfer.

Penalty on premature distributions

The penalty on premature distributions is 10%. This rate is applicable to any distributions made after De. 31, 1986, which are subject to the penalty. Distributions allocable to investment in contracts before Aug. 14, 1982, are not subject to the penalty.

Order of distributions

Because of the number of different rules which could apply to a single annuity contract, it is necessary to understand the order in which amounts subject to the various rules can be withdrawn. Periodic withdrawals from annuities held by individuals are categorized in the following order:

1. investments made before Aug. 14, 1982;
2. gain attributable to investments made before Aug. 14, 1982;
3. gain attributable to investments made on or after Aug. 14, 1982, and before Jan. 19, 1985 (subject to a 10% penalty on premature distributions attributable to such investments made within the 10-year period prior to the distribution);
4. gain attributable to investments made on or after Jan. 19, 1985 (10% penalty tax on premature distributions attributable to such investments); and
5. investments made on or after Aug. 14, 1982.

Distributions from annuity contracts held by someone other than a natural person are categorized in the following order:

1. investments made before Aug. 14, 1982;
2. gain attributable to investments made before Aug. 14, 1982;
3. gain attributable to investments made on or after Aug. 14, 1982, and before Jan. 1985 (subject to a 10% penalty on premature distributions attributable to such investments made within the 10-year period prior to the distribution);
4. gain attributable to investments made on or after Jan. 19, 1985, and before Feb. 28, 1986 (subject to a 10% penalty tax on premature distributions attributable to such investments);
5. investments made on or after Aug. 14, 1982, and before Feb. 28, 1986; and
6. gain attributable to investments made on or after Feb. 28, 1986 (no part of the distribution would be subject to tax because the income on the contract would have already been taxed).

Section 1035 exhanges

Under Section 1035 of Internal Revenue Code, an annuity contract may be exchanged for another annuity on a tax-free basis. In order to obtain this tax treatment, certain conditions must be satisfied. The regulations provide that in order to avoid gain or loss on the transaction, the same person or persons must be the obligee or obligees under the contract received in the exchange as under the original contract.

An important issue regarding Section 1035 exchanges is the income tax treatment of distributions from the contract received in the exchange. As we have seen, the taxation of the distribution varies depending on the date of the contract or the date of the contribution. The most favorable treatment is afforded amounts attributable to contributions made prior to Aug. 14, 1982. The Committee Report states that “a replacement contract obtained in a tax-free exchange of contracts succeeds to the status of the surrendered contract for purposes of the new provisions”. The Service affirmed this result in Revenue Ruling 85-159, 1985-2 CB 29. Consequently, when a pre-Aug. 14, 1982, contract is exchanged for another contract, the new contract is taxed in the same manner as the original one would have been. Periodic withdrawals are treated as return on investment first and there is no penalty on premature withdrawals.

Conclusion

The taxation of annuities has gone through many changes. The result is a labyrinth of rules when the same contract includes contributions which span the period of changes. Perhaps the best approach for avoiding this complexity is to keep contributions from different phases in this evolution segregated in separate contracts. For those contract owners who have already mixed contributions subject to different tax rules in one contract, a very careful and thorough analysis is necessary before they can be accurately advised about the tax consequences of transactions with their policies.