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Over the past several years, many insurance companies have become aggressive sellers of non-qualified annuities. The tax questions raised as a result of these sales are amazing both in number and complexity. We have based this article on numerous inquiries from agents of client companies and now share it with the readers of Life Insurance Selling.

Living benefits: Annuity distributions – withdrawals before the annuity starting date.
One element that sets the annuity apart from bank accounts and other saving forms is the deferral of taxation until annuity cash values are distributed. If an annuity contract was issued for premiums deposited before August 14, 1982, the annuity owner may withdraw the cash value tax-free until total withdrawals equal the owner’s investment in the contract. Subsequent withdrawals are taxable, being a return of credited interest or other earnings. The owner is taxed on a first in- first out (FIFO) basis. The owner may exchange a pre-August 14, 1982, annuity for another annuity contract and retain the right to make withdrawals tax-free up to his or her basis.

The law changed in 1982. For contracts issued after August 13, 1982, the initial dollars withdrawn, borrowed, or used as security for a debt are a taxable return of interest or other earnings credited. Thus, the owner is taxed on a last in-first out (LIFO) basis.

The owner who bought an annuity before August 14, 1982, but made deposits both before and after that date, will report income on withdrawals, loans or pledging of the annuity in the following priority: (1) pre-August 14, 1982, deposits (2) interest credited on pre-August 14, 1982, deposits, both before and after the August, 1982 dates, (3) interest credited on post-August 13, 1982, deposits, and (4) post-August 13, 1982, deposits. Withdrawals are made first from the lowest numbered category; the next category is used when a category is exhausted.

The 10% tax on premature distributions.
Tax law discourages the use of an annuity as a short-term investment. A 10% added tax is imposed on certain premature distributions from an annuity contract. The effect of the tax is to increase the levy on a withdrawal of credited interest, for example, to a 38% rate for an annuity owner in the 28% tax bracket. Nine non-qualified annuity distributions are not subject to the added tax. Of importance in the non-qualified annuity setting are these: (1) a payment made after the taxpayer (the annuity owner) turns age 591/2; (2) a payment attributable to a disability of the owner after purchase of the contract; (3) a payment allocable to deposits made to the annuity prior to August 14, 1982, including earnings on those investments; (4) a payment made after the death of the annuity owner; (5) payments made as an immediate annuity with payments commencing within a year of purchase; and (6) a series of substantially equal periodic payments for the life or life expectancy of the owner or the joint lives or joint life expectancies of the owner and a designated beneficiary. Payments under the last exception are subject to recapture if the payment schedule is changed prior to the owner’s age 591/2 or within five years of the first payment.

“A series of substantially equal payments.”
Internal Revenue Service Notice 89-25 provides three methods for taking a series of substantially equal payments and not triggering the 10% added tax. The third of the three methods is the most helpful because it generates the greatest annual distribution.

The method uses the insurance company’s current annuity purchase rate and solves for the answer by multiplication. The multiplicand is the number of thousands of dollars of annuity cash value; if the cash value is $100,000, the multiplicand is 100.

The multiplier is the company’s current annuity purchase rate, for example, $7.50 per $1,000 per month for a male, age 50, multiplied by 12 to make it an annual rate. The product is the amount that must be withdrawn annually from the contract until after five years of payments and the taxpayer’s reaching age 591/2. Following the above example, the product would be $9,000 per annum ($7.50 x 100 x 12).

The series of substantially equal payments for a non-qualified variable annuity are calculated similarly, except the value of the current annuity purchase unit is used as the multiplier in the above calculation. Unlike the fixed annuity calculated above, variable annuity payments will vary. In PLR 9115041, the IRS ruled the series of substantially equal payments exception won’t apply if the method the taxpayer selects doesn’t create a fixed or determinable payment stream. The method elected can’t be a discretionary withdrawal.

Thus, to abide by the ruling, the annuity owner who desires to make pre-age 591/2 withdrawals should agree in writing not to revoke the payment election until the later of five years following the first payment or attaining age 591/2. The insurance company will provide the election form and the annuity endorsement.

The benefits of an irrevocable election are: First, if the payments are made from a non-qualified annuity, the owner may use the exclusion ratio and exclude from income a portion of the annual payment received as a return of premiums paid; Second, the taxable portion isn’t subject to the 10% added tax.

Payments after the annuity starting date.
As mentioned above, the exclusion ratio returns to the owner tax-free the amounts paid for the contract. The ratio is expressed as a percentage found by dividing the investment in the contract by the expected return. For a life annuity, the expected return is the monthly payment times the annuitant’s life expectancy at the annuity starting date. More simply, the investment in the contract may be divided by the annuitant’s expectancy. The quotient is the amount of the annuity that is excludable from the owner’s gross income. After the investment in the contract is recovered, the subsequent annuity payments are entirely taxable. There are separate calculations for joint and survivor and variable annuities and for the period certain or deposit refund feature.

The college annuity.
The tax deferral during the accumulation phase makes the annuity an attractive purchase to fund a child’s college education. A greater sum is created when the full yield is retained. The grandparent or parent who buys an annuity for this purpose should be aware the 10% added tax applies if the child or the parent (if under age 591/2) owns the contract during the annuity’s payout phase, the child’s college years. What is taxable is the profit in the contract. For example, assume the child owns the contract. The child pays income tax on only the annuity profit at a base tax rate of, perhaps, 15%, plus the 10% added tax. The child’s total rate is usually less than if the grandparent or parent owns the annuity and pays the taxes.

Last Updated: 9/23/2012 10:05:00 PM