Annuities and Insurance
Quckfinder pages 14-20 and 15-25 through 15-28
Non-qualified annuity – lump sum the earnings come out first and the basis comes out second. If you annuitize there is a pro-rated portion of earnings and basis that come out in each payment and if at some point you pull out more than the basis (years down the line) then it will be all earnings. Both scenarios are taxed at ordinary income tax rates. No step up in basis on non-qualified annuity owners death.
Penalty on earnings if taken pre 59 ½
No penalty for beneficiaries due to death exception.
Ø For federal income tax purposes, how are annuities classified?
An annuity is a series of payments under a contract made at regular intervals over a period of more than 1 full year. They can be either fixed (under which you receive a definite amount) or variable (not fixed).
Publication 575 page 4
Ø What is a fixed annuity
Fixed annuities are a tax deferred investment that allow you to lock in a rate of earning that, even over long periods of time, remains unaffected by market ups and downs. The principal investment and a specified interest rate are both guaranteed.
Ø What is a variable annuity?
A variable annuity is a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and then pays you a level of income in retirement that is determined by the performance of the investments you choose.
Ø Who are the parties to an annuity contract?
There are four parties to an annuity contract: the annuity issuer, the owner, the annuitant, and the beneficiary. The annuity issuer is the company (e.g., an insurance company) that issues the annuity. The owner is the individual or other entity who buys the annuity from the annuity issuer and makes the contributions to the annuity. The annuitant is the individual whose life will be used as the measuring life for determining the timing and amount of distribution benefits that will be paid out. The owner and the annuitant are usually the same person but do not have to be. Finally, the beneficiary is the person who receives a death benefit from the annuity at the death of the annuitant.
Ø Are death distributions from an annuity taxable?
When the owner of the annuity dies and the beneficiary distributes the annuity to themselves, anything above the cost basis is taxable as ordinary income, no 10% penalty since distributions are due to death.
Ø Does an annuity receive a step-up in basis when the owner dies?
Annuities do not receive a step up in basis at death.
No they do not.
Publication 575
https://www.putnam.com/literature/pdf/II786.pdf
Ø Are annuities includable in the owner’s gross estate?
Annuities are included in the owner’s gross estate.
Ø What is the non-natural person rule?
A major benefit of annuities is that the earnings are tax deferred and nothing is taxed until distributions occur or the annuity is annuitized. However, if a trust or any other non-natural person is the owner of the annuity contract, the tax deferral feature is lost and the earnings are taxable in the year they are earned. There are exceptions to this rule such as: An annuity contract will be treated as owned by a natural person even if the owner is a trust or other entity as long as that entity holds the annuity as an agent for a natural person.
Ø What are the exceptions to the 10% penalty for distributions from an annuity?
General exceptions. The 10% tax penalty does not apply to distributions that are:
Made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from a qualified retirement plan, the payments must begin after separation from service).
Made because you are totally and permanently disabled
Made on or after the death of the plan participant or contract holder.
Ø Is there a taxable event when the ownership of an annuity is changed?
If an individual transfers ownership of a non-qualified annuity issued after 4/22/87 the owner must pay income tax on the earnings in the contract at the time of the transfer (except for transfers to a spouse or transfers made to a former spouse incident to a divorce). If the contract was issued before that date, the earnings in the contract can continue to be deferred, with the old cost basis carried over to the new owner. Transfer of ownership includes the addition or deletion of a joint owner. Also, the transfer of ownership may result in gift tax consequences for the owner.
Ø What distribution options are generally available to the beneficiaries of an annuity contract?
Beneficiary options can vary from one provider to the next so the beneficiary will have to confirm with the provider exactly what their options are for distributing the annuity. If there is a named beneficiary (natural person) of an annuity contract, the IRS allows the following options:
immediate lump sum
complete withdrawal(s) within 5 years of death
annuitization (over the life of the new owner) to start within one year of death. If spouse is sole surviving owner (or beneficiary), spouse can also elect to continue contract.
Note: If owner is a grantor trust, death of grantor triggers mandatory distribution
Ø What are the potential tax consequences of terminating an annuity contract?
When an annuity is surrendered, the taxpayer pays ordinary income tax on any earnings. The return of their cost basis is tax-free. If taxpayer is under 59.5 there is also a potential 10% penalty.
Ø What are the tax consequences if there is only a partial withdrawal from an annuity contract?
Partial distributions are considered to consist of the earnings portion first. Any earnings distributed are taxed as ordinary income and potential 10% penalty if under age 59.5.
Ø Can losses realized on the termination of an annuity contract be deducted?
There is no longer a deduction for losses from an annuity contract. Losses from an annuity contract used to be able to be reported as a miscellaneous itemized deduction subject to the 2% of AGI floor, but after-tax reform all of those deduction are gone.
Ø What are the income tax or penalty implications when an annuity is liquidated at a loss?
If an annuity contract is surrendered without any earnings, the cash received is considered a return of basis and it will be tax-free.
Ø Are annuities subject to the RMD rules?
The IRS does not impose RMD requirements on non-qualified annuities. However, the client should check with their annuity provider to confirm what their specific rules are on when the annuity must be annuitized.
Ø What are the potential tax consequences of distributions from a “qualified” annuity contract?
Qualified annuity contracts are just annuities held within an IRA or retirement plan. The tax rules will follow the same rules as IRA or retirement plan distributions depending on the type of plan it is.
Ø Are annuities gains taxed as capital gains or ordinary income?
Annuity earnings are taxed as ordinary income.
Ø How are annuities that have been annuitized taxed?
Annuitized distributions from a non-qualified annuity are taxed pro-rata and a portion of your payment will be a tax-free return of your basis. Once you have recovered your entire basis, any remaining payments will be fully taxable as ordinary income.
Ø What is a 1035 Exchange?
1035 refers to a provision in the tax code which allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy or annuity policy to another life insurance policy, endowment policy or annuity policy, without creating a taxable event.
This transfer option is a like-kind exchange in which no tax is due at time of transfer.
http://www.law.cornell.edu/uscode/text/26/1035
Ø What types of exchanges qualify for 1035 treatment?
A tax-free section 1035 exchange is the exchange of:
(a) a life insurance contract for another life insurance contract, or for an endowment or annuity contract, or for a qualified long-term care insurance contract;
(b) a contract of endowment insurance for another contract of endowment insurance that provides for regular payments to begin no later than they would have begun under the old contract, or for an annuity contract, or for a qualified long-term care insurance contract; or
(c) an annuity contract for an annuity contract or for a qualified long-term care insurance contract;
(d) a qualified long-term care insurance contract for a qualified long-term care insurance contract.
1099r instructions
Ø Can you explain how a partial 1035 exchange works and how the cost basis is affected?
A partial 1035 exchange is when only part of an existing annuity contract is exchanged for another. For example, if I have one annuity with a value of $10,000 and cost basis of $8,000 and do a 1035 exchange of only half of the policy, I now have two policies with a value of $5,000 and cost basis of $4,000. The contract holder must not take a distribution from either policy for 180 days for the partial exchange to remain valid. If the policy holder takes a distribution in the 180-day window, the policies are aggregated and treated as one for purposes of determining the taxable portion of the distribution.
Ø What is a premium tax?
Since the mid-1800s, insurance companies in many states have been assessed a type of excise tax on the premium dollars they receive from their customers. This state levy on premiums is akin to a sales tax charged to the seller ("insurance company") but usually passed on to the buyer. State premium taxes on annuities are usually applied at the time you purchase a new immediate annuity or when you annuitize an existing deferred annuity.
Ø Can distributions from a non-qualified annuity be rolled over into another annuity tax-free if done within 60-days?
60-day rollovers are not permitted for non-qualified annuities. Only way to transfer one annuity to another is through a 1035 exchange.
Ø How do you report an annuity distribution on an income tax return?
Annuity distributions are reported on IRS Form 1040 Lines 4a and 4b.
Ø Are life insurance death benefits subject to income tax?
Proceeds from a life insurance policy paid because of the death of the insured are generally not taxable income. An exception to this rule would be if the policy was transferred for valuable consideration before the death of the insured.
Publication 525 page 21
http://www.law.cornell.edu/uscode/text/26/101
Ø How is a distribution of the cash value of life insurance policy taxed?
Distributions from the cash value of a life insurance policy are generally treated as a return of basis first. Once you have recouped your entire basis, any earnings distributed would be taxed as ordinary income. Note: If the policy is a MEC contract than it would follow annuity rules which are earnings are distributed first.