Non-Qualified Annuity Tax Rules

Annuities are becoming increasingly popular. Long-term savings advantages; insurance of income stream for life; and the tax-deferring nature of the product, allowing earnings on the premiums to avoid income taxation until distributions are made, is continually increasing their appeal. As a consequence of their rising popularity, the past few years have brought a significant increase in the number of available annuity products. A result of their favorable tax status and increased popularity, the tax rules governing annuities are complicated. (This article continues below the calculator...)

Immediate Annuity Calculator

Here is an immediate annuity calculator. It calculates the amount of monthly income you will receive in return for a specific "Premium." Premium is the purchase amount you pay to the insurance company. With this calculator you can also find how much Premium would be necessary in order to receive a specific monthly income amount. To use the annuity calculator, simply highlight your age, state, and gender. Then enter a dollar amount in only one of the two boxes labeled "Premium" or "Monthly Income." Click "Calculate" and you will see a table with annuity quotes. Feel free to call 800-872-6684 if you have any questions about annuities or the quotes.

Types of Annuities

Annuities are classified in a number of different ways. For federal tax purposes, annuities are classified as either qualified or non-qualified. A qualified annuity is purchased as part of, or in conjunction with, an employer provided retirement plan or an individual retirement arrangement (such as an Individual Retirement Annuity or a Simplified Employee Pension Plan). If certain requirements are satisfied, contributions made to qualified annuities may be wholly or partially deductible from the taxable income of the individual or employer making the contributions.

A non-qualified annuity is not part of an employer provided retirement program and may be purchased by any individual or entity. Contributions to non-qualified annuities are made with after-tax dollars and are not deductible from gross income for income tax purposes. For the purposes of this article, we will limit further discussion to non-qualified annuities.

Annuities are also classified by type of investment and type of payout. Under a fixed annuity, the owner has both the security of a set rate of return and no investment decisions related to the annuity funds. The title "fixed annuity" does not mean that the earnings rate credited will never change; rather, it means that the earnings rate is set periodically by the issuer and then "fixed" until the rate is changed again.

Non-Natural Owners

Tax Treatment:

Contracts owned by "non-natural" persons are subject to annual tax on the inside buildup in the contract.

Exceptions:

• Held as a trust or other entity as an agent for a natural person
• Immediate Annuities
• Acquired by an estate upon the death of the owner

Not taxable to:

• charitable organizations
• pension plans
• Contracts issued on or before 2/28/86

The owner of a variable annuity has the ability to allocate contributions among underlying mutual funds. The rate of return is dependent upon the performance of those investment options, and there is no guarantee that the investment will not decline. The owner has the potential for earning a greater return than on a fixed annuity, but also assumes the risk of investment decisions. By law, a variable annuity is considered a security, and the contract must be registered with the Securities and Exchange Commission. Agents who sell variable annuities must be registered representatives with the National Association of Securities Dealers (NASD), as well as licensed insurance agents.

Recently, some companies have begun to market an equity indexed annuity. This annuity is something of a hybrid between fixed and variable annuities. Under an equity indexed annuity, the owner's principal is usually guaranteed and the rate of return is linked to a stock market index, such as the Standard & Poor's 500.Annuities are also classified as immediate or deferred. An immediate annuity is one which is purchased with a single premium and requires payments to begin within one year of purchase of the annuity. A deferred annuity does not have any set payment start date.

Commonly Asked Questions About Annuities

Who are the parties to an annuity contract?

The three parties to an annuity contract are the owner, the annuitant, and the beneficiary. In many instances, the owner and the annuitant will be the same.

The owner is usually the purchaser of the annuity and has all the rights under the contract, subject to the rights of any irrevocable beneficiary. The owner is subject to income tax on all payments made from the annuity, regardless of who is named as payee. If applicable, the penalty on any premature distributions is based on the owner's age. If the owner dies while the contract is in the accumulation phase (discussed later), there is a mandatory distribution of the death benefit.

The owner may be a natural or non-natural person. Some examples of non-natural persons are corporations, partnerships, and trusts. Generally, annuity contracts owned by non-natural persons are not treated as annuity contracts for federal income tax purposes and the earnings on such contracts are taxed annually as ordinary income received or accrued by the owner during the taxable year. As with many other income taxation rules, there are several exceptions to the non-natural owner rule.

For example, an annuity contract will be treated as owned by a natural person if the owner is a trust or other entity which holds the annuity as an agent for a natural person. However, this special exception will not apply in the case of an employer who is the nominal owner of an annuity contract under a non-qualified deferred compensation arrangement for its employees. Immediate annuities are also excepted from the non-natural owner rule.

The owner names the annuitant and the beneficiary of the annuity contract. The annuitant must be a natural person and serves as the measuring life for purposes of determining the amount and duration of any annuity payments made under the contract. The beneficiary receives the death benefit or any remaining annuity payments upon the death of the owner.

Aggregation

Aggregation Rule

All contracts issued by the same company to the same policyholder during any calendar year will be treated as one contract for purposes of computing taxable distributions

Exceptions:

• Annuitized contracts
• Immediate annuities
• Distributions required on death of owner
• Contracts issued prior to 10/21/88
  Note: If a pre-10/21/88 contract is subsequently exchanged or transferred, the new contract becomes subject to aggregation.

Premature Distribution Penalty

Penalty:

10% of taxable amount.

Exceptions:

• The owner is over age 59½
• The owner is disabled after contract purchase
• The owner, not the non-owner annuitant, dies
• Pre-TEFRA (prior to 8/14/82 contributions) non-qualified money
• Immediate non-qualified annuity

Substantially equal payments

• must continue for 5 years or until owner reaches 59½, whichever is later
• must be computed based on life expectancy
• Annuitization (for the owner's life or life expectancy

Note: An exchange from a deferred to an immediate annuity does not qualify as an immediate annuity for the purposes of avoiding tax penalty.

Tax Consequences of Ownership Changes

Types:

• Addition/deletion of joint owner
• Transfer to another individual or entity
• Assignment

Taxation:

• Earnings are subject to income tax at time of transfer
• 10% penalty may apply
• Gift taxes may apply

Exceptions:

• Transfers between spouses
• Transfers incident to divorce
• Transfers between an individual and his/her grantor trust

Mandatory Distribution upon Death of Owner

If Owner dies Prior to Annuitization:

Surviving owner (or beneficiary) must elect one of the following:

• 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. If owner is a grantor trust, death of grantor triggers mandatory distribution

Mandatory distribution applies to all contracts issued after 1/18/85

If Owner Dies After Annuitization:

Payments continue to beneficiary, based on annuitant's life and type of payment plan chosen

What are the phases of the annuity contract?

There are two distinct phases of the annuity contract: the accumulation phase and the annuitization phase. During the accumulation phase, the owner generally is not taxed on the earnings credited to the cash value of the annuity contract unless a distribution is received. The accumulation phase continues until the annuity contract is terminated or the annuitization phase begins. The annuitization phase starts when the contract value is applied to an annuity payout option. This phase continues until the last payment is made according to the annuity payout period chosen by the owner (or in some cases, the beneficiary).

How are the distributions taxed during the accumulation phase?

When an annuity contract is fully surrendered during the accumulation phase, the owner must pay income tax on the earnings in the contract. The owner is not taxed on amounts that represent a return of contributions (such as premiums or investment in the contract). Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis. In order words, withdrawals from an annuity are made earnings first, and the owner is taxed on the payments until all of the earnings have been distributed. There is an exception to the earnings first rule for contributions made to annuity contracts prior to 8/14/82. These contributions are distributed on a first in, first out (FIFO) basis and the owner is not taxed until such contributions are fully recovered.

There is an aggregation rule which requires that all annuity contracts issued by the same company, to the same owner, in the same calendar year must be treated as one annuity contract for purposes of determining the taxable portion of any distributions.

How are distributions taxed during the annuitization phase?

During annuitization, a portion of each annuity payment represents a return of non-taxable investment in the contract and the balance of each payment is considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio. The exclusion ratio for a fixed annuity is the ratio the investment in the contract bears to the expected return under the contract. The exclusion ratio for a variable annuity is determined by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered using the exclusion ratio, the annuity payments are fully taxable. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner in his last taxable year.

When does the 10% penalty tax apply?

The 10% penalty tax generally applies to the taxable amount of distributions from annuities made before the owner attains age 59½. However, there are exceptions for distributions: (1) made as a result of the owner's death or disability; (2) made in substantially equal periodic payments over the life or life expectancy of the owner, or joint lives or joint life expectancy of the owner and designated beneficiary; (3) made under an immediate annuity; or (4) attributable to investment in the annuity made prior to 8/14/82.

What are the tax consequences of a transfer of ownership?

If an individual transfers ownership of a non-qualified annuity issued after 4/22/87, without full and adequate consideration, 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.

What about Collateral Assignments?

Individuals who assign their annuities as collateral for loans may be surprised by the treatment of assignments. Generally, any collaterally assigned, pledged, or received as a loan under an annuity issued after 8/13/82 is treated as if it was distributed from the annuity. The amount collaterally assigned is taxed according to the rules applicable to partial withdrawals and full surrenders and may also be subject to the 10% penalty tax. If the entire contract is assigned or pledged, then earnings subsequently credited to the contract are automatically deemed subject to the assignment or pledge and are treated as additional partial withdrawals.

What happens at the owners' death?

Distributions

If the owner dies after the annuitization phase has begun, the remaining payments, if any, must be paid out at least as rapidly as under the annuity payout option in effect at the time of the owner's death. If a beneficiary receives the remaining payments under the annuity payout option in effect at the owner's death, the taxable and nontaxable portions of such payments will continue to be determined by the original exclusion ratio.

Withdrawals

Pre-TEFRA Contracts (Prior to 8/14/82):

• Principal out first - Not taxable
• Earnings outlast - fully taxable, but no penalty tax

Post TEFRA Contracts (After 8/13/82)

• Earnings out first - Fully taxable and may be subject to penalty tax
• Principal out last - Not taxable

Notes:

If a pre-TEFRA contract is subsequently exchanged, it keeps pre-TEFRA tax treatment. Sub-accounts are combined to compute income in the contract.

If the owner dies during the accumulation phase, the entire death benefit must be distributed within five years of the date of the owner's death. However, there is an exception to the five-year rule, if the death benefit is paid as an annuity over the life, or a period not longer than the life expectancy, of the beneficiary and the payments start within one year of the owner's date of death. If an annuity contract has joint owners, the distribution at death rules are applied upon the first death.

Under a special exception to the distribution at death rules, if the beneficiary is the surviving spouse of the owner, the annuity contract may be continued with the surviving spouse as the owner. If the owner of the annuity is a non-natural owner, then the annuitant's death triggers the distribution at death rules. In addition, the distribution at death rules are also triggered by a change in the annuitant on an annuity contract owned by a non-natural person. Income Tax. Unlike death benefits paid from life insurance policies, the beneficiary may be taxed on distributions made from an annuity after the owner's death. Amounts paid under the five-year rule are taxed in the same manner as partial withdrawals or full surrenders, and amounts paid under an annuity option are taxed in the same manner as annuity payments. For variable annuity contracts issued on or after 10/29/79, and for all fixed annuity contracts, there is no "step-up" in basis for income tax purposes and the beneficiary pays income tax on the earnings. However, the beneficiary is entitled to deduct a portion of estate tax paid on the annuity for income tax purposes. For variable annuity contracts issued prior to 10/21/79, there is a "step-up" in basis for income tax purposes and no income tax is payable on the earnings.

Estate Tax

For federal estate tax purposes, the total value of the contract is subject to estate tax. Except as noted above, annuities are income in respect of a decedent and there is no "step-up" in basis for the contract and the annuity is subject to income tax when distributed.

You should not rely on the information at this website for legal or tax opinions. You are strongly advised to consult with your own qualified legal and tax professionals before purchasing an annuity.

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