Taxation of Annuities
Tax Treatment Upon Death
The tax treatment of an annuity's death and survivor benefits is can be quite complicated. Upon a contractholder's (or annuitant's) death, the annuity may be subject to both income taxation and estate taxes. There are different tax treatments depending on who the beneficiary is, whether the owner annuitized the account, the payout method selected by the beneficiary, etc. We'll start with estate taxes first, and then look at income tax treatment.
The federal estate tax is a highly progressive tax (there are many tax brackets, each with a higher rate) with rates as high as 55% for very large estates. Upon death, the IRS will include all property over which the decedent had control at the time of death. While revocable trusts and other estate planning vehicles are useful for avoiding the cost and inconvenience of probate — these planning tools will not avoid estate taxes. If the decedent exercised control or held "incidents of ownership" over property when he or she died, the estate tax will apply. To summarize a very complex system, the value of all assets controlled by the decedent at the time of death will be totaled up, certain deductions will be subtracted (the two most generous deductions are for any property left to a surviving spouse or charity), and the appropriate tax rate is applied to the balance. Each taxpayer is then granted a "unified credit" to offset the tentative tax. Any tax in excess of the unified credit is due and payable nine months after the decedent's death. The unified credit will fully shelter relatively modest estates from this tax. So for many clients, estate taxation may not be an important issue. For larger estates, however, estate taxes can impose a large burden. Not only can the tax bill be quite large, but the short timeframe to pay the taxes may also place the estate and survivors in a "liquidity squeeze".
This discussion will focus on the estate tax treatment of annuities. As was the case during the contractholder's lifetime, the IRS makes a critical distinction between annuities held by a decedent that are in the accumulation phase and those that have entered the annuity (or payout) phase.
If the annuity is in the accumulation phase, i.e., the decedent has not yet annuitized the contract; the full death benefit guaranteed by the contract (including any enhanced death benefits) will be included in the taxable estate. For fixed annuities, this is usually the premiums invested plus the guaranteed rate of return accumulated until the time of death. For variable annuities, this is generally the greater of the investment in the contract or the contract's cash value at the time of death (although the enhanced death benefit rider may provide for more generous benefits.)
If the annuity has been annuitized, the value of any remaining annuity payments will be included in the taxable estate:
¨ if the contractholder selected a straight life payout method, the annuity payments stop upon his death and there is nothing to include in the estate
¨ if the contractholder selected an annuity with contingent payments for a beneficiary, the value of any remaining payments to the beneficiary will be included in the estate
¨ if the contractholder was receiving a joint and survivor payout, the estate must include the value of the survivor's annuity payments
The value of the remaining payments is the amount the same insurance company would charge for an annuity providing the same projected payments from the time of the decedent's death. Let's take a look at a few examples.
Example 1: Dorothy owned a fixed annuity contract issued by ABC Annuity Company at the time of her death. When she annuitized the contract twelve years ago, she selected a life annuity with 15-year period certain. The annuity has been paying her $1,200 per month. Since the contract guarantees payments for a minimum of 15 years, this leaves three years of payments to be made to her son, Ron, her designated beneficiary. Dorothy's executor will contact ABC to find the current price to purchase a fixed period annuity that will pay $1,200 for three years. That value will be included in Dorothy's estate for tax purposes.
Assume instead, that Dorothy annuitized this contract 18 years ago. At the time of her death she had outlived the 15-year period certain. Upon her death, the payments stop -- there is nothing to be paid to Ron, so there is nothing to include in her estate.
Example 2: Ed purchased an annuity from XYZ Annuity Company years ago. Two years ago he annuitized the account selecting a lifetime with cash refund payout option, naming his daughter Cindy as beneficiary. At the time of his death, there was $40,000 principal remaining in the contract. XYZ will pay Cindy the $40,000 and Ed's executor will include that amount on Ed's estate tax return.
Example 3: Geraldine and Miles, a married couple, own a joint and two-thirds survivor annuity issued by Acme Annuities. The annuity was paying $1,500 per month at the time of Miles' death, when Geraldine was 78 years old. After Miles' death, Acme will reduce the survivor annuity payments to 2/3rds of the joint payments; Geraldine will receive $1,000 per month for the rest of her life. Miles' executor will contact Acme to find out what it would cost to provide a 78-year old woman with a $1,000 per month lifetime annuity. That value will be included in the tally of taxable assets in Miles' estate.
Since Geraldine and Miles were married, the benefits payable to Geraldine represent property passing to a surviving spouse. The estate will be able to use the unlimited marital deduction to avoid taxation of these annuity benefits (the value of the benefits will be listed on the estate tax form, along with an offsetting marital deduction). Assume instead that Geraldine and Miles were cohabitating “without benefit of clergy”. In this case, Miles' estate would include the value of the remaining annuity payments, but there would be no marital deduction to offset that inclusion. The same would apply if this were Gerald and Miles, a same-sex couple.
Please note that the annuity's remaining value is determined at the time of death. The company's interest rate assumption or mortality tables may have changed since the annuity was originally issued — so the executor needs to obtain a current valuation as of the date of death.
Income Taxation of Death Benefits
The income tax provisions regarding annuity death/survivor benefits are complex. Part of this complexity is due to IRS requirements on how quickly the beneficiary must receive the death benefits.
If the contract has been annuitized (i.e., the contract has been paying annuity payments to the decedent), the IRS requires that any remaining payments to beneficiaries be paid at least as rapidly as was the case before the decedent's death. In other words, beneficiaries may take remaining payments more quickly, but cannot extend the payout period. If any portion of the annuity still contains principal, that principal will be returned to the beneficiary tax-free, then any taxable earnings will be paid. This is a FIFO-type distribution: tax-free return of principal first, then taxable earnings. After the contractholder's death, all income tax liability on future annuity payouts is the responsibility of the beneficiary who receives the payout.
If the contract remains in the accumulation phase at the time of the contractholder's death, the income tax rules become very complex. Annuity contracts can be either "annuitant-driven" or "owner-driven". These terms refer to whose death will trigger payment of death benefits. if the contract pays death benefits upon the death of the annuitant, it is an annuitant-driven contract. If the death benefit is payable upon the death of the contractholder, it is an owner-driven contract. In most cases, the owner and annuitant are one in the same, so this becomes a distinction without a difference. But there are situations in which one person owns the contract, and the measuring life (the annuitant) is someone else.
It would be nice to think that a particular contract is either owner-driven or annuitant-driven, but it is not that simple. All annuity contracts issued since January 18, 1985 are owner-driven because no annuity contracts issued since then will be granted tax-deferred status unless it contains language that triggers a payout upon the contractholder's death. To keep their tax status, annuity companies make sure their contracts provide payout upon the contractholder's death. That is not to say, however, that the contract cannot also provide for death benefits to be paid if the annuitant dies, too. And there are other complications: the "owner" for certain tax purposes must be a "natural person", so contracts held by trust or corporations may have another person named as "owner". With these caveats in mind, let's turn our attention to the distribution options available when the contract is still in the accumulation phase at death, and the annuity is “owner-driven”..
The general rule is that the beneficiary must take the contract's entire death benefit within five years of the contractholder's death. There are two exceptions to this general rule, and both are available only to "designated beneficiaries", which the tax code defines as "any individual designated a beneficiary by the holder of the contract". The key word is "individual" -- meaning a natural person, not a corporation, trust or other non-human entity. This five-year general rule and two following exceptions apply only when the owner's death triggers the payout. Annuitant-driven payouts are discussed below.
The first exception to the general five-year rule for individual beneficiaries is to accept the death benefit over a longer period, not to exceed the expected lifetime of the beneficiary. This allows the beneficiary to take the death benefits as an annuity payable for a lifetime or some shorter period. If the beneficiary elects to take the death benefits in this method, the benefits are taxed like any other annuity payments: partly as tax-free return of principal and partly taxable income. The exclusion ratio is found by using the deceased contractholder's cost basis and the expected payouts based on the beneficiary's life expectancy (of shorter period, if that is what the beneficiary chooses). [A few annuity companies allow beneficiaries to use a fractional method instead of annuitizing the death benefit. In this method, sometimes called a "stretch annuity", the beneficiary takes a withdrawal each year -- the required amount of each year's withdrawal is based on the same tables used to calculate the required distributions from an IRA. There are two advantages to this method. One, the account is not annuitized so the beneficiary retains control over the cash value in the contract. Two, smaller payments are allowed in the earlier years, leaving more in the contract to grow tax-deferred (or put another way, less will be taxed in the early years). In is unclear whether the IRS will tax this series of withdrawals the same as annuity payments, i.e., apply an exclusion ratio, or whether the beneficiary will be taxed on a LIFO basis, earnings first, then principal.] Regardless of whether the beneficiary annuitizes the death benefit or takes periodic withdrawals, the beneficiary must begin to receive the death benefits under this exception no later than one year after the contractholder's death. There are inconsistencies in the wording of tax code that might require the beneficiary to make a decision to use this exception to the general five-year rule within 60 days of death.
The second exception to the five-year rule is available only to a surviving spouse. If the designated beneficiary is the contractholder's spouse, the spouse may elect to "step into the shoes" of the decedent. In effect, the spouse is treated as if he or she were the owner of the annuity from its inception. In this case the spousal beneficiary can continue to hold the annuity in the tax-deferred accumulation period indefinitely. Please note this applies only if the spouse is named as a "designated beneficiary"; it is not available, for instance, if a trust is the beneficiary and the spouse is the trustee.
The general five-year rule and the two exceptions only apply to owner-driven annuities, not annuitant-driven contracts. Annuitant-driven contracts will pay death benefits when the annuitant dies. An annuitant-driven contract might be an older contract, issued prior to 1985, or it may be a newer contract that triggers a death benefit if either the annuitant dies (under the contract's terms) or the contractholder dies (under the tax code). For purposes of this discussion, assume that the annuitant and the owner are different. If the contract is annuitant-driven and the annuitant dies, the death triggers the death benefits — and the beneficiary has 60 days to decide how to take the death benefits subject to the terms of the annuity contract. If not annuitized within 60 days, the benefit will be taxed as though it were received in a lump-sum surrender, i.e., the cost basis will be returned tax-free, and any excess will be taxable in the year of the annuitant's death. Also note that the option of a spouse to "step into the shoes" of the owner will not be available -- that exception applies only when the owner has died — but the owner didn't die in the instance, the annuitant did. Lastly, if the beneficiary is under age 59˝, the "death" exception to avoid the 10% penalty will not apply to a premature distribution — again, because that is available only on the death of the contractholder (not the death of the annuitant). For these reasons, it is rarely a good idea to establish an annuitant-driven contract unless the owner and the annuitant are the same person. In fact, many annuity companies have internal underwriting policies that refuse to issue contracts that name a different owner and annuitant. (There may be odd situations in which an annuitant-driven contract fulfills a client’s unique needs, but more often than not the tax disadvantages will outweigh the benefits.)
Jointly-owned annuities may pose similar problems -- or at least they may not serve the estate planning function that other jointly-held assets do. Under the owner-driven annuity tax rules, death benefits are triggered upon the death of any owner. As a result, the death benefits must be paid out within five years of the first owner's death, or subject to the two exceptions (annuitization or spousal continuance). If an annuity is held jointly between a husband and wife it would appear that if one were to die, the other could simply continue ownership under the spousal continuance exception. But that exception only applies if the "designated beneficiary" is the spouse. Assume that the husband and wife named their son as beneficiary of their jointly-owned annuity. Upon the death of either owner, the company must pay the death benefits to the son, who is the beneficiary, not the surviving spouse — and this would probably defeat the owner's intentions. At a minimum, this example points out the complexity and uncertainty that jointly-held annuities pose. Some financial planners use jointly-owned annuities when planning for long-term care needs — jointly-owned annuities are sometimes useful in divesting assets to qualify for Medicaid nursing home benefits. Financial advisors should be very careful before recommending the joint ownership of annuities. If a jointly-owned annuity is deemed appropriate, the advisor should seek expert tax advise, carefully review the terms of the contract, and the issuing company’s internal administrative policies to improve the chances of the contract ending the way it was planned.