Understanding Annuity Proceeds

What are annuity proceeds?

“Amounts received as an annuity”

Annuity proceeds include “amounts received as an annuity” as defined in the regulations issued under the tax code. For amounts received under an annuity contract to qualify as “amounts received as an annuity,” all of these requirements must be met:

The amounts must be received on or after the annuitization starting date. The annuitization starting date is the first day of the first period in which annuity payouts are received under the contract. Thus, if annuity payouts are made each December 31, and if the first annuity payout will be made on December 31 of Year 1, the annuitization starting date is January 1 of Year 1.
The amounts must be part of a series of distributions made at regular intervals over a period of more than one year.
The total amount to be paid must be determined, as of the annuitization starting date, from the terms of the contract, mortality tables, compound interest tables, or some combination of these factors.

Proceeds payable to beneficiaries

Annuity proceeds also include distributions made to beneficiaries (i.e., those who receive the remaining benefits after the death of the owner or annuitant). Proceeds paid to beneficiaries are called death benefits.

Amounts not received as an annuity or non-annuity payout distributions (NADs)

Annuity proceeds can also include nonannuity payout distributions (NADs). For example, owners of annuity contracts often receive dividends with respect to such contracts, make withdrawals from the cash surrender value of such contracts, or receive cash upon the surrender of such contracts.

How are annuity proceeds distributed?

Pure life annuities

A pure life annuity contract is one that makes payouts only as long as the owner lives. The insurer gets to keep any premiums paid when the owner dies, even if the total paid out is less than the amount invested.

Tip: If the annuitization starting date is after July 1, 1986, a deduction may be taken on the decedent’s final income tax return for the unrecovered investment in the contract at the time of the owner’s death.

Life with period certain annuities

A life with period certain annuity policy guarantees that a certain number of annuity payments will be made (typically for 5, 10, or 20 years) or until the owner dies, whichever is longer. Any remaining guaranteed annuity payments at the time of the owner’s death are made to the beneficiary named in the contract.

Period certain annuities

A period certain annuity policy pays a specified amount for a stipulated term only.

Refund annuities/lump sum or installment

Refund annuity policies pay the difference between the amount invested (i.e., total premiums paid) and the annuity payouts actually received. Refunds are paid either in a lump sum or in installments to a named beneficiary at the death of the owner.

Variable annuity death benefits

Variable annuity death benefits refer to proceeds received by a beneficiary when the owner of a variable annuity contract dies before the variable annuity payouts begin. The amount of the death benefit generally equals the greater of the current value of the account at death or total amount of premiums paid into the annuity less any withdrawals.

Tip: The current value of the account may be less than the total premiums actually paid. Some insurers guarantee a minimum death benefit equaling the total premiums paid less any withdrawals. There is generally a charge for this option.

Caution: Guarantees are subject to the claims-paying ability of the issuing insurance company.

Caution: Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity or from your financial professional. You should read the prospectus carefully before you invest.

How are annuity proceeds classified for income tax purposes?

Return of investment or return of capital

Your investment in an annuity contract generally is equal to the total amount that has been paid for the annuity policy, with some special adjustments.

Income or interest or growth

Income with respect to an annuity contract is earnings on premiums paid on the policy. This income is not subject to income tax until distributed if the contract is held by a natural person.

Annuity payments

Generally, annuity payments that are “amounts received as an annuity” are treated as part return of capital and part income.

Cash surrender value

The cash surrender value of an annuity contract refers to how much you (the owner of the contract) would receive if you surrendered the contract.

NADs

NADs refer to proceeds of loans, secured by an annuity contract, the proceeds of surrenders of annuity contracts, withdrawals, dividends, and other amounts not received as an annuity received by you (the owner of an annuity contract).

How are annuity proceeds treated for income tax purposes?

Return of capital

Proceeds classified as return of capital are not subject to income tax.

Undistributed income when owner is a natural person

If the owner of an annuity contract is a natural person, income with respect to the contract is generally not subject to income tax until such income is distributed.

Undistributed income when owner is not a natural person

The tax-free buildup of income within an annuity contract is allowed for natural persons only. Thus, if the owner is an entity (e.g., corporation, employer, or trust), the income on the contract each year is taxable to the owner as ordinary income. There are some exceptions to the “natural person” rule:

Annuities held by a qualified retirement plan or individual retirement account.
Qualifying funding assets (i.e., annuities used to fund structured settlements and periodic payments for damages). Structured settlements are used by insurance companies to pay damage awards in civil suits. State lotteries may also use structured settlements to pay large jackpots.
Immediate annuities (i.e., an annuity purchased with a single premium, the annuitization starting date of which is within one year from the date of purchase of the annuity, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period).
Annuity contracts received by a decedent’s estate by reason of the death of the decedent.
Annuities purchased by an employer on termination of a qualified plan.
Annuities held by certain trusts (e.g., grantor trusts) or other entities as agent for a natural person are considered held by a natural person.

Death benefits

Any amount received by a beneficiary that is in excess of the total premiums paid is treated as ordinary income for income tax purposes.

Caution: Death benefits from annuities are not taxed the same as benefits from life insurance, which are generally not subject to income tax.

NADs made before the annuitization starting date on policies entered into before August 14, 1982

For policies that were entered into before August 14, 1982, NADs made before the annuitization starting date are treated as return of investment in the contract first, and any remaining amounts are treated as ordinary income, subject to income tax.

NADs made before the annuitization starting date on policies entered into on or after August 13, 1982

For policies that were entered into on or after August 13, 1982, NADs made before the annuitization starting date are treated as ordinary income to the extent that the cash value of the contract exceeds the investment in the contract, and any remaining amounts are treated as tax-free return of capital. The purpose of this “interest-first” rule is to prevent the use of the tax-deferred inside buildup as a method of sheltering income on short-term investments.

NADs made on or after the annuitization starting date

Generally, NADs made on or after the annuitization starting date are treated as ordinary income, subject to income tax, unless the distribution represents proceeds from a complete surrender of an annuity contract, in which case the preceding rules apply.

Caution: Generally, NADs made before the annuitization starting date that are subject to income tax are also subject to a 10 percent penalty.

There are some exceptions to this general rule:

NADs made when the taxpayer is 59½ or older
NADs made on account of the taxpayer’s disability
NADs made under an immediate annuity (i.e., an annuity purchased with a single premium, the annuitization starting date of which is no more than one year from the date of purchase of the annuity, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period)
NADs made on or after the death of the owner who is a natural person
NADs made on or after the death of the annuitant if the owner is not a natural person
NADs allocable to pre-August 14, 1982, investments
NADs that are part of a series of substantially equal periodic payments made for the life of the taxpayer or the joint lives of the taxpayer and his or her beneficiary for the greater of 5 years or until the taxpayer reaches age 59½

How is income tax on amounts received as an annuity calculated?

Part return of investment, part income

Annuity proceeds in the annuitization phase are deemed to be part nontaxable return of capital and part taxable income.

Exclusion ratio

The exclusion ratio is the percentage of the proceeds that is nontaxable return of capital. To calculate the exclusion ratio, divide the investment in the contract (i.e., total premiums paid) by the expected return on the annuity policy. The expected return of an annuity policy is the total amount receivable under the policy and is determined using actuarial tables published by the IRS.

Example(s): Joe purchases an annuity contract for $15,000. His expected return is $23,500. The exclusion ratio is $15,000/$23,500, or 64 percent. If Joe receives $1,200 a year as an annuity, the amount that he can exclude from his taxable income is $768 ($1,200 X 0.64).

Caution: This basic formula is a little more complex when joint and survivor annuities are involved. A tax specialist may be necessary for these computations.

Are annuity proceeds subject to estate tax?

Proceeds payable to the decedent’s estate

Any annuity proceeds paid to the decedent’s estate are includable in the decedent’s estate for estate tax purposes.

Proceeds payable to a survivor or beneficiary

Owned by spouses–When an annuity is jointly owned by spouses, one-half the present value of the annuity interest is includable in the decedent’s gross estate.
Unmarried joint owners–When a jointly owned annuity is held by owners who are not married, the value included in the decedent’s gross estate is based on the respective contributions of the joint owners.

Example(s): Bill and Bob buy an annuity. Bill pays 75 percent of the purchase price. When Bill dies, 75 percent of the present value of the remaining payouts that will be made to Bob is includable in Bill’s gross estate.

Beneficiaries–Proceeds payable to a spouse qualify for the unlimited marital deduction, while proceeds payable to a qualified charity qualify for the estate tax charitable deduction.

In conclusion, understanding annuity proceeds is vital for making informed financial decisions. Scarlet Oak Financial Services is here to guide you through the complexities, whether you’re considering pure life annuities, life with certain periods of annuities, or variable annuity death benefits. Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our newsletter with the latest economic news.

Source:

Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.

Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.