Question

discuss the importance of determining the taxable amount from the return of capital amounts from annuities and qualified retirement plans

Answer 1

Premiums

If an annuity contract is part of an employer-sponsored retirement plan, such as a 401(k), premiums are plan contributions and generally not includible in the employee’s income when paid. However, if an annuity is used in a “Roth” type of arrangement, such as a Roth 403(b) annuity, the premiums are includible in income. Premiums paid for an IRA annuity may be deductible in whole or in part. For a non-qualified annuity, premiums are paid with after-tax monies and are not tax deductible.

Tax Deferral

Dividends, interest, and capital gains credited to an annuity are not taxed until they are withdrawn. In other words, earnings are tax deferred and reinvested to help accumulate assets for retirement. As a result, money may be transferred from one investment option to another inside a variable annuity without incurring a tax liability. This is not true for taxable investments, in which transferring amounts from one investment to another, such as from one mutual fund to another, will be treated as a sale and any gains will be taxable.

If a deferred annuity contract is not owned by an individual, but rather by an entity such as a corporation, the contract is not eligible for tax deferral in most cases. Rather, the entity is taxed each year on the increase in the net surrender value of the contract, minus premiums paid during the year. (Special rules allow trusts and other entities to own an annuity and still be eligible for tax deferral in certain circumstances.) Congress enacted this requirement to ensure that the tax deferral granted by annuities is used primarily as a vehicle for individuals’ retirement savings.

Withdrawals

When a contract owner begins to receive money from an annuity, distributions taken in excess of the amount invested are subject to taxation at the owner’s ordinary income tax rate. Just as with IRAs, 401(k) plans, and other tax-qualified plans, when money is withdrawn, it does not receive favorable capital gains treatment. As discussed below, however, annuity income payments receive more favorable tax treatment than lump sum payments or withdrawals. Also, unlike qualified plans, income payments under a non-qualified annuity can be deferred past age 70½ and taken when the need arises.

Because Congress set the rules on tax deferral to encourage long-term retirement savings, withdrawals made before age 59½ may be subject to a 10% federal tax penalty on the taxable amount of earnings withdrawn, in addition to any income taxes due on that amount. (There are exceptions to the 10% penalty.) This is similar to the 10% penalty tax on premature distributions from IRAs and underscores the fact that annuities are designed to be long-term retirement vehicles. (There also may be surrender charges, if the withdrawal exceeds any annual free-withdrawal amount or the surrender charge period has not run out. Surrender charges are imposed by the terms of the contract and should not be confused with the 10% federal tax penalty.)

For non-qualified annuity contracts, the tax rule on withdrawals is “interest and earnings first.” Under this rule, interest and earnings are considered withdrawn first for federal income tax purposes. For example, if someone invested $25,000 in a fixed or variable annuity and the contract is now worth $45,000, the first $20,000 withdrawn is taxable. The remaining $25,000 is not taxed because it is considered a return of principal. Withdrawals are taxed until all interest and earnings are withdrawn; the principal then can be withdrawn without tax.

The “interest and earnings first” rule is intended to encourage the use of annuities for long-term savings and retirement. Congress decided that the advantage of tax deferral should not be accompanied by the ability to withdraw principal first, with no tax payable until all principal is withdrawn. Different rules apply to tax-qualified annuities (such as IRAs), under which withdrawals are taxed on a pro rata basis to the extent there were any after-tax contributions made to the contract.

Complete Surrenders

When an owner surrenders an annuity contract, the excess of the amount received over the owner’s investment in the contract is taxable. Generally, the investment in the contract is the amount of premiums paid (less any principal that has been previously returned to the contract owner without tax) at the time of distribution.

Gifts and Assignments of Annuity Contracts

If a contract owner gives an annuity contract as a gift, the contract owner may have to pay income tax at the time of the transfer. The contract owner must include in income the difference between the cash surrender value of the contract and the owner’s investment in the contract at the time of the transfer. This rule does not apply if the transfer is made between spouses or former spouses as part of a divorce. (Gift taxes also may apply.)

In addition, any assignment or pledge of (or agreement to assign or pledge) any portion of an annuity contract’s cash surrender value is treated as a withdrawal of such amount from the contract. Hence, the tax treatment that normally applies to withdrawals also applies to assignments or pledges of annuity contracts.

Premature Distributions

For non-qualified annuities, a 10% federal tax penalty may apply to the taxable portion of an amount received before age 59½. There are exceptions to the 10% penalty, for example, if the payment is made upon the owner’s death or disability. As noted earlier, this penalty is intended to encourage the use of annuities for retirement savings purposes. For that reason, similar penalties generally apply to withdrawals from IRAs and qualified plans, which also are intended for retirement savings.

Taxation of Annuity Payouts

Annuity owners can elect a number of payout options. The basic rule for annuity payouts (as distinguished from withdrawals or other non-periodic payments) is that the money a contract owner invests in the contract is returned in equal tax-free installments over the payment period. The remainder of the amount received each year is treated as the earnings on the owner’s premiums and is included in income. The income portion is taxed at ordinary income tax rates, not capital gains rates. The total amount that is received tax free can never exceed the premiums the owner paid for the contract.

The taxable portion of each payment is equal to the excess of the payment over the “exclusion amount.” With a fixed annuity, the exclusion amount generally is computed by (a) dividing the premiums paid for the annuity by the total expected return from all scheduled annuity payments, and (b) multiplying each payment by this “exclusion ratio.” With a variable annuity, because the expected return cannot be predicted, the exclusion amount is generally computed by dividing the premiums paid for the contract by the number of years that payments are expected to be made. For a lifetime annuity, the expected return is always computed by reference to the annuitant’s life expectancy as determined using IRS tables.

To illustrate, assume that a male age 65 elects a lifetime annuity and his investment in the contract is $100,000. Assume further that he has elected to receive annual variable annuity payments and the payment for the first year is $8,000. Since the payments are variable, they will vary each year thereafter. (For simplicity, this illustration assumes annual annuity payments, although monthly or quarterly payments are more common.) Applicable IRS tables indicate that such a person is expected to live 20 years. The portion of each annuity payment excluded from income is $5,000, which is $100,000 divided by 20. During the first year, $5,000 of the $8,000 will be excluded from income and $3,000 will be included and taxable. The $5,000 is excluded each year until the total investment in the contract has been received.

Partial Annuitizations

In some cases, the owner of a deferred annuity contract may wish to apply only a portion of the contract’s cash value (rather than the entire cash value) to produce a series of annuity payments under the contract, while leaving the contract’s remaining cash value in the deferral or accumulation stage. For example, the owner’s current financial need may be for annuity payments that are less than the payments the contract’s full cash value would produce, or the owner may wish to “ladder” or “stagger” annuity payments to take advantage of future changes in annuity purchase rates. Prior to 2011, there was no specific rule in the tax code regarding such “partial annuitizations.” Starting in 2011, however, the tax code provides that partial annuitizations of non-qualified annuities are treated the same as other annuitizations, as long as the resulting annuity payments are made for a period of at least 10 years or over the life or lives of one or more individuals. In such cases, the annuitized and non-annuitized portions of the contract are treated as separate contracts and the after-tax investment in the contract is allocated pro rata between them for purposes of applying the rules governing the taxation of distributions.

Death of an Owner

When an owner of an annuity dies, the general rule is that certain distributions must be made. (Similar rules apply to qualified plans.) The tax policy behind this rule is to prevent the prolonged deferral of income tax on the gains in an annuity contract that would occur if ownership could be passed from person to person without taxation occurring.

If an owner dies on or after the annuity commencement date, but before the entire interest in the contract has been distributed (e.g., if the owner dies five years into a 10-year guaranteed payout term), the remaining portion must be distributed at least as rapidly as under the method of distribution in effect at the time of death.

If an owner dies before the annuity commencement date, the general rule is that the entire interest in the contract must be distributed within five years after the date of the owner’s death. Under this rule, a beneficiary has the following choices:

• Take the amount due under the contract and pay taxes at that time.
• Make withdrawals over the course of the next five years and pay taxes on each withdrawal, with the remainder of the contract value growing tax deferred.
• Wait up to five years with the contract value growing tax deferred, then take the entire amount due and pay taxes.

An exception to the five-year rule described above is available for cases in which payments are made to a beneficiary over life or life expectancy. Specifically, within 12 months of the owner’s death, a beneficiary can (a) annuitize the remaining interest over his or her life or life expectancy and receive the favorable tax treatment accompanying annuity payments, or (b) begin withdrawals over a period not exceeding the beneficiary’s life expectancy, calculated in a manner specified in IRS rules, and pay taxes on each withdrawal on an income-first basis.

For purposes of the foregoing after-death distribution rules, if an individual is the owner under a contract and the spouse is the beneficiary, then following the owner’s death the surviving spouse is treated as the “owner” of the contract. In such case, the after-death distribution rules take effect upon the surviving spouse’s death, rather than upon the original owner’s death.

In the case of a non-natural owner (such as a corporation), the foregoing after-death distribution rules apply on the death of the primary annuitant.

Replacement Contracts/1035 Exchanges

When a contract owner purchases a new annuity contract to replace an existing one, the new contract is referred to as a replacement contract. Replacement contracts usually occur in connection with a tax-free exchange of non-qualified contracts under Section 1035 of the Internal Revenue Code, or because of a rollover or direct transfer of a qualified plan contract (e.g., an individual retirement annuity) from one life insurance company to another. Annuity owners generally can exchange their annuity contracts for new ones, tax free. In both qualified plans and non-qualified annuities, depending upon the terms of the contract, it also may be possible to transfer, tax free, a portion of the contract to a new contract issued by the same or a different carrier, while continuing the remaining portion of the contract from which the partial transfer was taken. Special rules must be followed to assure that either a complete or a partial exchange or transfer qualifies for tax-free treatment.

The reasons for an exchange of annuity contracts can include:

• The owner has a fixed annuity with a substantially lower interest rate than other contracts currently available.
• The company that issued the current contract is not as financially strong as it was in the past.
• The new contract may have better features, such as an enhanced death benefit, guaranteed minimum income benefit, portfolio rebalancing, or dollar cost averaging.
• The new contract may have more or better-performing investment options.
• The new contract may have lower fees and charges.

Many states have passed regulations requiring certain procedures be followed before an annuity contract is replaced. The contract purchaser and the agent must sign a statement as to whether the contract being purchased will replace an existing one. If so, the new insurance company must promptly notify the old insurance company. The new insurance company must provide the purchaser with a prescribed statement about important factors to consider before buying the replacement contract. In some cases, a surrender charge may be incurred by exchanging the old contract and a new surrender charge period may start on the new contract. For this reason, an individual and his or her financial advisor should carefully evaluate a proposed exchange to ensure that it is in the contract owner’s best interest. States have adopted replacement regulations ensuring full disclosure in these situations and affording other protections. States also may provide longer free-look periods for replacement contracts than for other annuity contracts.

Medicare Tax on Investment Income

Beginning in 2013, distributions from non-qualified annuity contracts, to the extent not excludible from income, will generally be subject to the 3.8% Medicare tax on investment income for taxpayers with adjusted gross income (with certain modifications) over $250,000 in the case of married couples filing jointly and qualifying widow(er)s with dependent children, $125,000 in the case of married taxpayers filing separately, or $200,000 in the case of other taxpayers.