Taxation of Annuities
Income Tax Treatment During the Owner's Lifetime (con’d)
Amounts Not Received as an Annuity
Annuity payments are not the only way a contractholder may obtain funds from the contract. Contractholders can exercise control over a deferred annuity contract's value up until the time it is annuitized (i.e., during the accumulation phase). This is true of both fixed and variable annuities. The contractholder may surrender the entire contract, take a partial withdrawal, or exchange the contract for another. Each of these has a tax consequence.
Surrender. By surrendering the contract, the owner is simply "cashing in" his investment for a lump sum. The total investment in the contract is calculated as before, i.e., total premiums paid in to the contract less any dividends, withdrawals, or loans taken out. Return of principal is tax-free; any amount received in excess of the principal amount is taxable as ordinary income in the year it is received.
Partial withdrawal. Implicit in the discussion so far is that earnings in the contract grow tax-deferred; taxes are payable when the earnings portion of the account's value is taken from the contract. In the case of annuity payments, a portion of the earnings is released with each payment. In the case of surrender, the entire earnings portion is released in a lump sum. But what if only part of the account's value is released? Is the portion released considered taxable earnings, tax-free principal or a combination of the two? The answer to those questions depends on when the annuity contract was issued. For contracts entered into before August 14, 1982, the IRS assumes that the first monies withdrawn from the contract represent the first monies in the contract. (This is sometimes called the first-in, first-out method or FIFO). The first monies in the contract are the premiums the contractholder paid. The first sums withdrawn will represent the return of principal. Only after all of the tax-free principal is withdrawn will the contractholder start to receive taxable income.
For example, an investor contributed $60,000 to a deferred variable annuity in 1980. In 2004, when the contract is worth $195,000, the contractholder withdraws $40,000. That withdrawal is tax-free return of principal. The withdrawal does reduce the owner's investment in the contract (his "cost basis") to $20,000. In 2005, the contractholder withdraws another $30,000. This represents the last $20,000 of his original investment, and $10,000 of taxable earnings. All future withdrawals will be fully taxable since he has already withdrawn all the tax-free principal from the account. The opposite is true for contracts issued after August 13, 1982. The IRS applies a LIFO or last-in, first-out accounting method to these newer contracts. The last monies added to the contract's value (earnings) are the first to be withdrawn. Had the owner in the example bought the annuity in 1984, the 2004 and 2005 withdrawals would be fully taxable earnings. Only the last $60,000 taken from the account's value would be considered tax-free return of principal.
(In the mid-1980's, some contractholders sought ways to minimize the adverse nature of this change from FIFO to LIFO accounting. Instead of purchasing one contract, as in the above example, they would purchase a number of smaller contracts. Then, if part of the investment was needed in the future, they would surrender one of the contracts — this would allow part of the surrender to be treated as tax-free return of principal. The IRS deemed this an abusive practice. Today, all purchases of annuities within a calendar year from the same annuity company are treated as a single contract for tax purposes. Although, contracts purchased through different annuity companies will be treated separately.)
The FIFO/LIFO rules that apply to partial withdrawals also apply to other distributions during the accumulation phase, such as dividend payments, loans taken from the account (if loans are allowed by the contract's terms), or when the account is assigned as collateral for a loan. While loans are not usually allowed in most non-qualified annuity contracts, advisors should be aware that simply pledging the contract as collateral for a loan might trigger an adverse tax consequence for the contractholder.
Exchanges. Section 1035 of the Internal Revenue Code allows for some tax-free exchanges of life insurance products. Contractholders can exchange an existing annuity contract for another annuity contract. Life insurance policyholders can exchange their policy for another policy or an annuity contract. However, a tax-free exchange from an annuity contract to a life insurance policy is not permitted under Section 1035.
There are many reasons to exchange annuity contracts: to switch from a fixed to a variable contract, or vice versa; to upgrade to a higher-quality annuity company; to consolidate multiple annuities into one contract; to obtain less-restrictive contract terms; to obtain a contract with more favorable annuity payout factors or contract guarantees; etc.
When contractholders engage in a "1035 exchange", they simply carry their existing cost basis (investment in the contract) to the new annuity. Future tax treatment will be based on that original investment. Using the above example one more time: in 1980, a contractholder invested $60,000 in a deferred variable annuity that has grown to a cash value of $195,000. He now wants to exchange that contract for a $195,000 fixed annuity. Under Section 1035, there will be no tax consequence for the exchange, and his original $60,000 cost basis will apply to the new contract. Also note that the LIFO/FIFO nature of the existing contract is retained. In this case, the existing contract is subject to the more-favorable FIFO treatment (it was issued before 1982), and that treatment is applied to the new contract, too.
It is important to note that Section 1035 allows for additional investment to be made in conjunction with the exchange. The contractholder in the above example could exchange the variable contract plus another $55,000 for a $250,000 fixed annuity. The new cost basis would be $115,000 (the original $60,000 + the additional $55,000). The rules are less clear when a partial exchange is made. Suppose the contractholder exchanged the $195,000 variable contract for a $150,000 fixed annuity plus $45,000 in cash. In the past, the IRS fought taxpayers who would partially surrender a contract in exchange for a smaller contract, plus cash. The IRS feared this allowed the creation of small contracts as an abusive way to avoid the tax consequences of the LIFO accounting method (similar to the multiple contract concept discussed above). The IRS lost its arguments in tax court and now allows for partial 1035 exchanges, provided the taxpayer does not intend to surrender the new, smaller contract within two years of the exchange. The cash received from the partial exchange is called the "boot" and is usually taxable.
Section 1035 exchanges are very common events. Most financial advisors should become comfortable in understanding the process as it relates to simple this-for-that exchanges, and be able to explain the ramifications of those exchanges to clients. In the case of more complicated exchanges involving multiple contracts, unequal amounts, loan payoffs, etc., many financial advisors may want to consult an expert in the field before making a recommendation to their clients.
Penalty for Premature Distributions
When Congress granted the benefit of tax deferral to annuities it intended the contracts to be used as a retirement plan. To discourage the use of deferred annuities as a short-term investment vehicle for young people, Congress imposed a 10% penalty on "premature distributions". This 10% penalty is similar to the penalty imposed on early withdrawals from qualified retirement plans.
Generally speaking, the 10% penalty applies if withdrawals are taken from a non-qualified annuity prior to age 59½, but there are exceptions to this general rule. Withdrawals may be taken from a deferred annuity prior to age 59½ without penalty if:
¨ the owner dies,
¨ the owner becomes disabled,
¨ a series of substantially equal payments are scheduled for the owner's lifetime (or joint life expectancy of the owner and beneficiary), or
¨ the contract was issued before August 14, 1982.
Note that the 10% penalty generally applies to deferred annuities only. This penalty does not apply to annuity payments received from immediate annuities that are purchased outright. However, if a contractholder exchanges a deferred annuity for an immediate contract under Section 1035, those annuity payments are subject to the 10% penalty, unless one of the exceptions listed above applies. If the contractholder selects a lifetime payout method for the exchanged immediate annuity (as opposed to a payout over a specified period), she will receive substantially equal payments for a lifetime and thus avoid the 10% penalty using that exception.
The 10% penalty applies only to the taxable portion of a premature distribution. In other words, the penalty does not apply to tax-free return of principal. (Note: This is different than the penalty for premature withdrawals from qualified retirement plans, which applies to the entire withdrawal, not just the taxable earnings portion.)
Eligibility for Tax Deferral
Tax-deferred growth is one of the key selling points of an annuity -- but this feature is not available to all contractholders. Only "natural persons" enjoy a tax deferral. A "natural person" is a human being. If a corporation, partnership, trust, estate or other organization owns the annuity, it will not receive the same favorable tax treatment enjoyed by "natural persons". For these organizations, the growth in the account is taxable each year as it is earned. The annual earnings within the annuity are taxed as ordinary income each year. There are a couple of exceptions to this general rule:
¨ estates that receive an annuity upon death,
¨ annuities held in a qualified retirement plan,
¨ annuities purchased to replace payments from a terminated qualified retirement plan,
¨ single premium immediate lifetime annuities that pay out at least annually, or
¨ trusts or other entities that act simply as an agent for a natural person.
This last exception is an important one for clients who set up trusts. An annuity held in a trust may enjoy tax-deferred status if the trust simply holds the annuity as an agent for an individual. In many revocable living (inter vivos) trusts, the trust is simply a surrogate for the trust grantor during his or her life. There should be no problem with the tax status of annuities held in such trusts. Where the trust has another purpose, however, there may be adverse tax consequences if the trust owns an annuity. The same might be said for family limited partnerships, limited liability corporations, etc. — as these organizations usually involve more than simply holding assets for an individual. Before recommending the purchase of an annuity within one of these entities, advisors should seek expert tax advice.