ANNUITY TAX LAWS By: Edward J. Barrett

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1 ANNUITY TAX LAWS By: Edward J. Barrett Overview Federal tax law has traditionally encouraged the use of annuities by affording them favorable tax treatment, including deferral of any income from the accumulation phase to the distribution (payout) phase. Over the past fifteen or twenty years, however, there has been a dramatic change in the traditional picture. With the advent of the variable annuity, policyholders came to enjoy the same broad array of investment choices as mutual fund investors. This made the annuity very attractive to anyone who wanted these types of investments but did not want to pay tax currently on the interest, dividends and capital gains that they generate. Thus annuities became popular as a tax-favored investment and were marketed and sold to investors who had little or no interest in ever using them for retirement income. However, as annuity sales skyrocketed, Congress realized that the tax benefits intended to encourage retirement savings were also threatening to create a new tax-sheltered investment industry. Beginning with the Tax Equity and Fiscal Responsibility Act of 1982 ( TEFRA ) and continuing in a series of laws throughout the 1980 s, Congress has narrowed the favorable tax treatment of annuities to re-emphasize its original purpose of encouraging retirement savings (one obvious example: the 10% penalty tax on income withdrawn before age 59½). Keeping this theme in mind is useful as you attempt to understand the technical and seemingly disjointed special rules of annuity taxation discussed in this white paper. What is an Annuity for Tax Purposes? In general terms, an annuity contract is an insurance policy that promises the periodic payment of a sum of money for a term of years (a term certain annuity), for the life of an individual or the joint lives of several individuals (a life annuity), or both. How an annuity is viewed, however, depends upon the context in which it is considered. For instance, annuities have been described differently for federal securities law, banking, law, and tax law purposes. However, for federal tax purposes, we will focus on IRC 72, which is the principal Code provisions governing the taxation of annuity contracts. Premiums Premiums paid into an annuity for federal tax purposes can be 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

2 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 contributions. Premiums (contributions) to a qualified plan are limited by IRS code. 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. Premium contributions to a non-qualified annuity are only limited by the insurance company. IRC 72: Tax-Deferral Dividends, interest, and capital gains credited to an annuity are not taxed until they are withdrawn. This is true as long as the annuity meets certain requirements of IRC 72 and the owner of the annuity is a natural person. In other words, earnings are tax-deferred and reinvested to help accumulate assets for retirement. Because of this feature, 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, where moving funds from one investment vehicle to another, such as from one portfolio of a mutual fund to another portfolio of that fund will be treated as a sale and any gains will be taxed. IRC 72 (a) IRC 72 (a) provides that gross income includes any amount received as an annuity. IRC 72 (b): Exclusion Ratio Rule Annuities have historically been purchased to provide a stream of income over a period of years. Annuitization allows the owner of the contract to receive income over his or her life expectancy. In order to determine how the payments will be taxed, an exclusion ratio (which may be expressed as a fraction or as a percentage) must be established. This exclusion ratio is applied to each annuity payment to find the portion of the payment that is excludable from gross income for the year received. IRC 72 (b)(1). For annuities with a starting date after December 31, 1986, the exclusion ratio applies to payments received until the payment in which the investment in the contract is fully recovered. In that payment, the amount excludable is limited to the balance of the un-recovered investment. Payments received thereafter are fully includable in income. IRC 72 (b)(2). For annuity starting dates before January 1, 1987, the exclusion ratio applies to all payments received throughout the entire payment period, even if the annuitant has received his or her investment. For those contracts, it would be possible for a long-lived annuitant to receive tax-free amounts which in the aggregate exceed his or her investment in the contract. Fixed Annuity: With a fixed annuity, the exclusion ratio is established by dividing the premiums paid for the contract (investment in the contract IRC 72 (c)) by the expected

3 return, as determined by IRS tables (IRC 72 (c )(3)), and (2) multiplying the payment by such ratio. For Example, assuming that the investment in the contract is $12,650 and expected return is $16,000, the exclusion ratio is $12,650/$16,000, or 79.1%. If the monthly payment is $100, the portion to be excluded from gross income is $79.10 (79.1% of $100), and the balance of the payment is included in the gross income. If 12 such monthly payments are received during the taxable year, the total amount to be excluded for the year is $ (12 x $79.10), and the amount to be included is $ ($1,200 - $949.20). Variable Annuity: With a variable annuity, since the expected return cannot be predicted, the exclusion ratio is computed by dividing the premiums paid for the contract by the number of years payments are expected to be made. If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If, payments are to be made for a single life, the divisor is the appropriate life expectancy multiple (Treas. Reg (b)(3)) whichever is applicable (depending on when the investment in the contract was made) of the IRS Tables. For Example, assume that Mr. Jones, a 65-year-old male elects a life annuity and his investment in the contract was $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 payments are variable, they will vary each year thereafter). Applicable IRS Tables indicate that such a person is expected to live 21 years. One hundred thousand dollars divided by 21 is $4,762, which is the portion of each annuity payment that is excluded from tax. During the first year, $4,762 of the $8,000 will be excluded from income and $3,228 will be included. The $4,762 is excluded each year until the total investment in the contract has been received. Note: Once the total investment in the contract has been received any remaining payments will be 100% taxable. IRC 72 (c)(4): Annuity Starting Date The exclusion ratio for taxing annuity payments under a particular contract is determined as of the annuity starting date. This is the first day of the first period for which an amount is received as an annuity. For example, suppose that a person purchases an immediate annuity on August 1 st providing monthly payments beginning September 1st (the first payment is for the one-month period beginning August 1 st ). Hence, the annuity starting date is 8/1. IRC 72 (e): Lifetime Distributions When a contract owner begins to receive lifetime distributions from an annuity, amounts received in excess of amounts invested are subject to taxation at the owner s ordinary income tax rate (IRC 72 (e)). Just as with IRAs, 401 (k) plans and other qualified plans, when money is finally withdrawn, it does not receive favorable capital gains treatment. However, as we

4 discussed earlier, annuity payments receive more favorable tax treatment (an exclusion ratio-irc 72 (b)(1)) than lump sum or systematic withdrawals, and the flow of income from an annuity can be controlled so that assets continue to grow tax-deferred over an extended period of time. Annuity values accumulate tax-free until withdrawn. Specifically, amounts received by an individual from an annuity contract entered into after August 13, 1982, are taxable as ordinary income to the extent the cash value exceeds the investment in the contract. For Example: Bob, who is age 50 and in a 35% federal income tax bracket, purchases a variable annuity contract. The initial deposit is $100,000, all allocated to a growth fund sub-account. Three years later the contract has an accumulated value of $114,000 and a surrender value of $108,000. Bob withdraws $10,000 as a down payment for a vacation home. Since the cash value ($114,000) exceeds the investment ($100,000) by $14,000, the entire $10,000 is taxed as ordinary income, costing Bob $3,500 of tax ($10,000 x 35%). Note: All income from an annuity contract is ordinary income and none capital gain, even if the increase in the annuity s value is entirely due to capital gains in the underlying investment subaccount. Also the policy s surrender charge of $6,000 is disregarded for purposes of determining the amount that is taxable on a partial withdrawal. IRC 72 (e)(4)(a): Loans and Assignments Most non-qualified annuity contracts do not offer the option of taking a loan against the annuity values. This is probably due largely to the fact that any amount received as a loan under a contract entered into after August 13, 1982 is taxable to the extent that the cash value of the contract immediately before the loan exceeds the investment in the contract. IRC 72 (e) (4) (c): Gift of the Annuity Contract If an individual (the donor ) makes a gift of an annuity contract (issued after April 22, 1987) for less than full and adequate consideration, and the cash surrender value is greater than his or her investment in the contract, then the individual (donor) realizes in the year of the transfer any gain on the contract allocable to investment in the contract after August This rule does not apply between spouses (or between former spouses incident to a divorce and pursuant to an instrument executed or modified after July 18, 1984), except that it does apply to a gift of a contract in trust for a spouse to the extent that gains must be recognized because of any loan to which the contract is subject. Gift taxes may also apply. Any amount that a donor includes in income under this rule (basis adjustment) is added to the investment in the contract for purposes of figuring the income tax consequences of future distributions. If the cash surrender value of an annuity contract issued prior to April 23, 1987 at the time of the gift, exceeds the donor s cost basis, and the donee subsequently surrenders the contract, the donor must report as taxable income the gain existing at the time of the gift. In other words,

5 the donor is taxed on the difference between the premiums he or she paid and the cash surrender value of the contract at the time of the gift. The balance of the gain, if any, is taxed to the donee. IRC 72 (e)(5)(e) Gain in the Contract Generally, an annuity contract provides that if the annuitant dies before the annuity starting date, the beneficiary will be paid as a death benefit the amount of premium paid or the accumulation value of the contract. The gain, if any, is taxable as ordinary income. The death benefit under an annuity contract does not qualify for tax exemption under IRC 101 (a) as life insurance proceeds payable by reason of insured s death. Gain is measured by subtracting: 1. total gross premiums from 2. the death benefit plus aggregate dividends and any other amounts that have been received under the contract which were excluded from gross income. IRC 72(e)(11)(A)(ii) Aggregation Rules 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. For Example: Client A purchases five non-qualified deferred annuity policies in 2012 from ABC Life Insurance Company. For planning purposes, the client names a different beneficiary on each policy, thinking (wrongly) that this will avoid the aggregation rule. To make things simple, let s assume the investment in each is $50,000. Further, let s assume that two years later each policy has grown in value to be worth $60,000. Sometime after, Client A requests a distribution of $40,000 from one of the contracts purchased two years prior. The investment (tax cost basis) in each is $50,000, interest earnings in each policy at the time of withdrawal is $10,000, for a total gain of $50,000 in the five policies. Because the five polices are owned by the same owner and were purchased within the same calendar year from the same company, the values are aggregated to determine the amount of gain considered distributed when a withdrawal is requested. Since the withdrawal of $40,000 is less than the total gain in the five policies, the entire withdrawal is considered taxable. While the full amount was removed from a single contract, under the aggregation rules, the gain is determined on a global (aggregated) basis. Individual policy basis and gain tracking is effectively ignored. Exceptions to the Aggregation Rules: 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.

6 IRC 72 (t)(1): Additional 10% Penalty Tax on Early Distribution IRC 72(t) (1) imposes an additional tax on premature distributions from qualified annuity contracts (e.g., an IRC 403(b) annuity contract or an IRC 408 individual retirement annuity) that is similar to the penalty tax imposed by 72(q). IRC 72(t)(2)(A)(iv) also provides that the additional tax does not apply to a series of substantially equal periodic payments and IRC 72(t)(4) sets forth a recapture rule similar to the rule of 72(q)(3). IRS Notice provides guidance regarding the imposition of the additional tax on distributions from qualified employee plans, 403(b) annuity contracts, and individual retirement annuities (IRAs). Notice sets forth three methods for determining whether payments to individuals from their IRAs or from their qualified retirement plans constitute a series of substantially equal periodic payments for purposes of IRC 72(t)(2)(A)(iv). The three methods are: The Required Minimum Distribution Method. Under the required minimum distribution method, the annual payment for each year is determined by dividing the account balance for that year by the number from the chosen life expectancy table for that year. With this method, the account balance, the number from the chosen life expectancy table (See Rev. Rul (a) (life expectancy tables)) and the resulting annual payments are re-determined for each year. If this method is chosen, no modification in the series of substantially equal periodic payments will be deemed to occur, even if the amount of payments changes from year to year, provided there is not a change to another method of determining the payments. The Fixed Amortization Method. Under the fixed amortization method, the annual payment for each year is determined by amortizing in level amounts the account balance over a specified number of years determined by using the chosen life expectancy table and the chosen interest rate (See Rev. Rul (a) interest rates). With this method, the account balance, the number from the chosen life expectancy table and the resulting annual payment are determined once for the first distribution year and the annual payment is the same amount each succeeding year. The Fixed Annuitization Method. Under the fixed annuitization method, the annual payment for each year is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the taxpayer s age and continuing for the life of the taxpayer (or joint lives of the taxpayer and beneficiary). The annuity factor is derived using the mortality table to Rev. Rul and using the chosen interest rate. With this method, the account balance, the annuity factor, the chosen interest rate and the resulting annual payment are determined once for the first distribution year and the annual payment is the same in each succeeding year. Prior to 2002, Notice provided that the additional IRC 72(t) (1) tax would be imposed if (i) at any time before attaining age 59½ a taxpayer changed the distribution method to a method that does not qualify for the exception, or (ii) the taxpayer changed the distribution method within the five years after the receipt of the first payment. Rev. Rul modified notice by providing two exceptions to this rule.

7 First, an individual is not subject to the IRC 72(t)(1) additional tax if (i) the payments are not substantially equal because the assets in the IRA (or individuals account plan) are exhausted, and (ii) the individual followed one of the prescribed methods of determining whether payments are substantially equal periodic payments. Second, an individual who begins receiving distributions in a year using either the fixed amortization or fixed annuitization method may switch to the minimum distribution method for the year of the switch, and all subsequent years, and the change will not be treated as a modification within the meaning of IRC 72(t)(4). Any subsequent change, however, will be a modification for purposes within the meaning of IRC (t) (4). IRC 72(q)(1): Premature Distribution 10% Penalty Tax IRC 72(q)(1) imposes a penalty tax on certain premature or early distributions under a nonqualified annuity contract equal to 10 percent of the amount that is includible in gross income. The penalty tax is imposed on premature distributions received prior to the taxpayer s attaining age 59½ from non-qualified annuity contracts issued after January 18, The penalty does not apply to any part of a distribution that is tax free, such as amounts that represent a return of principal (cost basis) or that were rolled over to another retirement plan. The penalty tax will not be imposed, however, if the distribution satisfies one of the exceptions set forth in IRC 72(q)(2). IRC 72 (q)(2)(d) provides that a distribution will not be subject to the penalty tax if it is part of a series of substantially equal periodic payments (SOSEPP) made at least annually for the life (or life expectancy) or the joint lives (or joint life expectancies) of such taxpayer and his designated beneficiary. If the payments are subsequently modified, IRC 72(q)(3) generally requires a taxpayer to take into account the penalty tax, plus interest, that would have been imposed if IRC 72 (q)((2)(d) had not applied to the prior distribution. The penalty tax will also not apply to the following distributions from a non-qualified annuity contract: From a deferred annuity contract to the extent allocable to investment in the contract before August 14, 1982, From a deferred annuity contract under a qualified personal injury settlement, From a deferred annuity contract purchased by an employer upon termination of a qualified employee plan or qualified employee annuity plan and held by the employer until the employee separates from service, or From an immediate annuity contract (a single premium contract providing substantially equal annuity payments that start within one year from the date of purchase and are paid at least annually). The IRS and Treasury believe that, when the provisions of IRC 72 are intended to address different concerns with respect to the treatment of qualified and non-qualified annuities, it is appropriate to apply those provisions in a different manner. However, if the provisions of IRC 72 are designed to achieve the same purpose whether or not the annuity is qualified or nonqualified, it is appropriate to apply that provision in the same manner to both qualified and nonqualified annuities.

8 IRC 72 (s): Death Distribution Rules At Death of the Holder Section 72(s) (1), which was added to the Internal Revenue Code effective for contracts issued after January 18, 1985, states that a contract will not be treated as an annuity contract under IRC 72 and subtitle A purposes (meaning it would not be eligible for tax deferral) unless it provides the following: If, any holder of such contract dies on or after the annuity starting date and before the entire interest in the contract has been distributed, the remaining portion must be distributed at least as rapidly as under the method of distributions being used as of the date of the holder s death; and If, any holder of such contract dies before the annuity starting date, the entire interest must be distributed within five years after the death of the holder. Note: It is especially important to note that IRC 72(s) focuses on the holder. The holder has been interpreted to mean the owner of the contract. As you will see in our later discussion, in many cases, the owner will also be the annuitant under the contract. This can lead to some tricky planning and technical issues. To reiterate, if the holder dies before annuitization has begun, the general rule is that the contract proceeds must be distributed within five years of the holder s death. This rule is to prevent deferral of income on the gains in an annuity contract by passing ownership from person to another person without taxation occurring. However, there are exceptions to this rule, under IRC 72(s) (2) and (3), which provides two important exceptions: The first exception, under IRC 72 (s) (2), states that if: Any portion of the holder s interest is payable to or for the benefit of a designated beneficiary, That portion will be distributed over the life of such designated beneficiary (or over a period not extending beyond the life expectancy of such beneficiary); Distributions of that portion begin no later than one year after the holder s death, then, for purposes of the one-year rule under IRC 72(s)(1), that portion will be treated as fully distributed on the day the distributions begin. In other words, the death distribution rules will be satisfied by a payout over the life or life expectancy of the designated beneficiary as long as the payout begins within one year of the holder s death. Note: The term designated beneficiary is defined in Section 72(s)(4) to mean any individual designated a beneficiary by the holder of the contract.. The second exception, under IRC 72(s) (3), states that: If, the designated beneficiary is the holder s surviving spouse, then IRC 72(s)(1) is to be applied by treating the spouse, as the holder of the contract.

9 In other words, since the spouse, as holder, would be alive, there would be no required distribution as a result of the original holder s death. As noted, the required distribution rules apply when the holder dies. If the holder of the contract is not an individual, IRC 72 (s)(6)(a) provides that the primary annuitant is to be treated as the holder of the contract, meaning the death of the annuitant will trigger the required distribution rules. The term primary annuitant is defined in IRC 72 (s)(6)(b) as the individual, the events in the life of whom are of primary importance in affecting the timing or amount of the payout under the contract. IRC 72 (s)(7) states that when the holder is not an individual, and thus the death benefit of the primary annuitant would trigger the required distribution rules, any change in the primary annuitant is treated as the death of the holder. Finally, there are certain annuity contracts that are not subject to the required distribution rules of IRC 72 (s). Specifically, IRC 72 (s)(5) makes IRC 72 (s) inapplicable to the following: Annuity contracts provided under qualified plans covered by IRC 401 (a) or qualified annuity plans covered by IRC 403(a), Annuity contracts described in IRC 403(b), Annuity contracts that are individual retirement annuities or provided under individual retirement accounts or annuities, or Annuity contracts that are qualified funding assets. Note: Annuity contracts provided under qualified plans, such as 401 (a), 403(b) IRAs, etc. are subject to the required distribution rules of IRC 401 (a)(9)(6) rather than IRC 72 (s). IRC 72 (u): Non-Natural Person Rule Prior to 1986, the interest earned inside the annuity was tax deferred no matter who or what entity owned the annuity. However in 1986, Congress passed the Tax Reform Act of 1986, to prevent corporations and other non-natural persons from taking advantage of the tax deferral of an annuity. If an annuity contract is owned by a non-natural person (an entity), i.e., a corporation, and contributions are made to that contract after February 28, 1986 the earnings on those contributions are not eligible for tax-deferral in most cases. Thus, such an entity is taxed each year on the change in the net surrender value of the contract, issued after February 28, 1986, minus premiums paid during the year. Congress enacted this requirement (IRC 72 (u)) to ensure that the tax deferral granted by annuities is used primarily as a vehicle for individuals retirement savings. However, under IRC 72 (u) (3), there are some types of annuities to which this rule, which is often referred to as the non-natural person rule does not apply. These include any annuity contract that is:

10 Acquired by a person s estate at the persons death; Held under a qualified retirement plan, a Tax Sheltered Annuity (TSA), or an Individual Retirement Arrangement (IRA); Purchased by an employer upon the termination of a qualified retirement plan or TSA program and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or to his or her beneficiary; An immediate annuity (an annuity which is purchased with a single premium and begins payments within a year); and A qualified funding asset (an annuity contract issued by a licensed insurance company which is purchased to fund a payment for damages resulting from personal physical injury or sickness). Under IRC 72(u)(1), an annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person. In Priv. Let. Rule and , a trust that owned an annuity contract which was to be distributed, prior to its annuity date, to the trust s beneficiary, a natural person, was considered to hold the annuity contract holding as an agent not clearly required for a natural person (see PLRs (May 25,1999) & (Nov. 5, 1998). Further, a bank holding an annuity contract used to fund a pre-need funeral arrangement as trustee was considered to hold an annuity contract as an agent for a natural person, where the trust constituted a grantor trust. (PLR ). IRC 72 (u) (4): Defines an Immediate Annuity Internal Revenue Code Section 72(u)(4) defines an immediate annuity as an annuity purchased with a single premium or annuity consideration, with an annuity starting date no later than one year from the date of purchase and providing for a series of substantially equal periodic payments to be made no less than once a year during the annuity period. IRC Section 165: Claiming a Loss A loss deduction can be claimed only if the loss is incurred in connection with the taxpayer s trade or business or in a transaction entered into for profit [IRC 165]. Generally, the purchase of a personal annuity contract is considered a transaction entered into for profit. Consequently, if a taxpayer sustains a loss upon surrender of a refund annuity contract, he/she may claim a deduction for the loss regardless of whether he/she purchased the contract in connection with his/her trade or business or as a personal investment. The big question is: How does the taxpayer take the deduction and what is the amount of the deduction? For Example: Sara invested $100,000 in a variable annuity a few years back. The value of the annuity is now $80,000. Sara is told that if she cashes out the annuity, she'll have to pay a surrender charge of $5,000, leaving her with a total of $75,000. Given all of this, Sara decides to pull the plug, and the annuity company sends her a check for $75,000. Sara lost $25,000 in real dollars -- and that's the amount she can deduct on her tax return.

11 Remember that a deductible loss is realized only if the annuity is completely cashed out or otherwise surrendered. Note: If you conduct a 1035 exchange, any gain or loss on the prior annuity will simply be transferred into the new annuity, and there ll be neither income or deductions to report on the exchange. There is one silver lining to Sara s misfortune: She won't have to pay a penalty tax of 10% on any of the $75,000 distributed to her when she cashed out the annuity, even if she's not yet age 59 ½. The penalty applies only to gains on income when an annuity is cashed out. Since Sara actually lost money from her initial investment, she's spared the tax hit. You might think that Sara s $25,000 is a capital loss, to be reported on Schedule D with other investment losses, but that's not quite the case. The IRS has clearly ruled that losses like these are ordinary losses, not investment losses. And it gets even trickier when you look at where on the tax return to report the loss. Some say (more conservative approach) that the loss should be treated as a miscellaneous itemized deduction that is not subject to the 2% floor on miscellaneous itemized deductions. Others, say it is a miscellaneous itemized deduction subject to the 2% floor. So if you have high AGI -- let's assume that Sara's is $150,000, with no other miscellaneous itemized deductions the actual deduction will be limited to less than the loss. In this case, Sara's 2% works out to $3,000. Subtracting that from the $25,000 she lost in the annuity, she can only deduct $22,000. It can get worse: Large miscellaneous itemized deductions can wreak havoc with the alternative minimum tax (AMT). So claiming the loss as a miscellaneous itemized deduction is a tough route no matter what. (And if you don't itemize deductions, you'll be subject to the 2% hit and the standard deduction.) A more aggressive approach is the recommendation to take the loss using Form 4797, and then move that Form 4797 number directly to the front of the tax return under "other gains or losses." This method lets you deduct the full loss without that 2% bite. Additionally, you'll have no AMT issues, and the loss will help to reduce your AGI, which might help in many other ways. Note: In the 2007 edition of IRS Publication 575, page 20 (Pension and Annuity Income), the IRS says that a loss under a variable annuity is treated as a miscellaneous itemized deduction subject to the 2% floor. As the financial advisor, I would highly recommend that you consult your clients tax attorney to let him or her determine how much risk the client is willing to assume when preparing their tax return. If you'd like to read what little authority there is on this issue, visit the IRS website and check out Revenue Ruling (Rev. Rul.) and IRC Section 7702B(e)(1) The Pension Protection Act of 2006, signed into law on August 17 th, 2006 and effective 2010, allows life insurance and annuity companies to offer long-term care riders on top of regular

12 policies. It also provides that internal charges against the values in annuities and permanent life insurance policies used to pay long-term care insurance premiums aren t taxed. Section 844 of the PPA of 2006 was intended to expand accessibility to tax-favored long-term care insurance by providing the ability for life insurance and annuity contracts to add long-term care insurance riders and use the cash value to cover the cost of long-term care insurance premiums without incurring taxable distributions, effective after The new law broadens the provisions for Code Section 1035 tax-free exchanges to allow for exchange of life and annuity policies into long-term care insurance contracts (discussed below). IRC 1035: Tax-Free Exchanges Tax-free exchanges of annuity contracts play an important role in the annuity business. In order to appreciate their importance, consider that tax-free exchanges are like refinancing in the mortgage business. Just as homeowners are often looking for competitive interest rates, annuity owners are often looking for new product features and competitive returns. Annuity owners generally can exchange their annuity contract for a new contract, tax-free. There are several reasons why an annuity holder may want to be interested in such an exchange. They may be: The solvency of the insurance company that issued the existing contract. The interest rates currently being offered are higher than current contract. The new contract may have substantially better features and benefits. Desire for better guarantees and or investment options. IRC 1035 Requirements However, to assure the tax-free exchange the agent must make sure that the exchange meets certain IRS requirements. Some of the requirements are: The insured (or annuitant) on the new contract must be the same as on the old one. The owner on the new policy must also be the same as the owner on the old one. Basis (or investment in the contract) is carried over from the old contract to the new one. Generally, IRC 1035 provides that the following exchanges may be made without current income taxation: An annuity contract for another annuity contract; A life insurance policy for an annuity; An endowment contract for an annuity contract; A life insurance contract for another life insurance contract;

13 An endowment contract for an endowment contract which will begin making payments no later than payments would have commenced under the old contract. Note: The Pension Protection Act (PPA) of 2006 expanded the scope of IRC 1035 to include tax-free exchanges of qualified long-term care (LTC) contracts. Under Provision 824, it will also cover LTC provided as part of, or a rider to a life or annuity contract. This will become applicable to exchanges occurring after 12/31/09. Partial IRC 1035 Exchanges As discussed above, Internal Revenue Code ( IRC ) 1035(a)(3) permits taxpayers to transfer an annuity contract, life insurance or endowment policy from one insurance company to another insurance company without recognizing a taxable event. IRC 1035 has always permitted taxpayers to execute tax-free exchanges of entire contracts or policies; however, the Code and its accompanying regulations had never addressed the tax treatment of partial IRC 1035 exchanges. Consequently, insurance and annuity companies have been processing 1035 exchanges of entire insurance and annuity contracts for over 17 years but, due to the lack of guidance from the Internal Revenue Service ( IRS ), they have been reluctant to allow contract owners to enter into an exchange of anything less than an entire contract. The first indication that the IRS was considering changing its position regarding partial IRC 1035 exchanges came in 1998 when the Tax Court ruled in favor of a taxpayer who had exchanged a portion of an annuity contract from one company to another (Conway v. Commissioner, 111 T.C. 350 (1998), acq., C.B. xvi). In Conway, the petitioner asked the Tax Court to recognize the transfer of a portion of an annuity contract from one insurance company to another as a tax-free exchange under IRC 1035(a). The IRS did not challenge the Tax Court s favorable ruling, but rather issued an Action on Decision. In the Action on Decision the IRS indicated that they would not challenge the facts of the case, however they would continue to challenge similar transactions by taxpayers who entered into these partial 1035 exchanges for the purpose of avoiding taxes and penalties under IRC 72. The IRS s concern regarding the use of partial 1035 exchanges for the purpose of avoiding taxes and penalties arises because of potential abuse in the treatment of the cost basis between the original and the new contract. For example, when a contract owner enters into a 1035 exchange of an entire contract, the insurance company surrendering the contract and transferring the cash surrender value is responsible for providing the receiving company with the cost basis (premiums deposited) and gain (any amount above the original premium(s)) information on the original contract. The receiving company relies on the accuracy of that information in order to properly report the taxable portions of any future distributions on Form 1099R. The transmission of this information is not difficult when the entire contract is being exchanged. However, when only a portion of a contract is being exchanged, the question arises as to what is being transferred. Basis or gain? If the owner were to transfer all the gain to the new contract and leave the entire cost basis in the original contract, he could take distributions from the original contract and thus avoid paying any tax on the distributions. The aggregation rule would not apply. Of course, if the IRS did not allow partial 1035 exchanges, the contract would distribute gain first, which is taxable at ordinary income rates.

14 After Conway, the majority of annuity companies still did not permit partial 1035 exchanges, citing the IRS s warning and its lack of guidance on how to treat the annuity cost basis. Nonetheless, Conway was seen by some as an opening, after which some annuity companies did begin to allow contract owners to enter into partial tax-free exchanges of their annuity contracts. With no guidance, however, there was very little consistency within the industry regarding how partial 1035 exchanges were processed. As a result, some companies allowed contract owners to exchange a portion of their annuity contract on a LIFO (last in first out) basis, while other companies allowed partial exchanges on a pro rata basis (the portion exchanged is reduced equally between cost basis and gain). Inconsistencies in the processing of partial 1035 exchanges were due not only to the lack of guidance from the IRS but to companies systems and technological constraints. Revenue Ruling On July 8, 2003, the Department of the Treasury and the IRS issued Revenue Ruling This revenue ruling addressed the issue of partial 1035 exchanges of annuity contracts and outlined how such transactions would be considered valid tax-free exchanges. Specifically, the revenue ruling indicated that a taxpayer could transfer a portion of the cash surrender value within an annuity contract to another annuity contract at another company without realizing a taxable event on the amount transferred. Furthermore, the revenue ruling provided guidance with respect to the treatment of cost basis, stating that the portion of the cash surrender value exchanged should be reduced ratably between the cost basis and gain of the original contract. This concept is illustrated below. CONTRACT A Contract A s value before partial 1035 exchange $100,000 Cost basis before partial 1035 exchange (50%) $ 50,000 Gain before partial 1035 exchange (50%) $ 50,000 Partial 1035 exchange amount $ 60,000 Contract A s new value after partial 1035 exchange $ 40,000 Cost basis after partial 1035 exchange (50%) $ 20,000 Gain after partial 1035 exchange (50%) $ 20,000 CONTRACT B Contract B s value after partial 1035 exchange $ 60,000 Cost basis after partial 1035 exchange (50%) $ 30,000 Gain after partial 1035 exchange (50%) $ 30,000 To supplement the revenue ruling, the Treasury and IRS also issued Notice , which stated that the IRS would consider issuing regulations to deter taxpayers from entering into

15 partial 1035 exchanges for the purpose of avoiding taxes. For example, the IRS indicated that it might propose a rule that would require any surrender or distribution from either the original contract or the newly issued contract that occurs within 24 months of the partial 1035 exchange to be treated as if the two contracts were one for tax reporting purposes. In addition, the IRS would likely create safe harbor exceptions for certain withdrawals within the 24-month period, such as withdrawals due to disability or divorce, or substantially equal periodic payments under IRC 72 (q). In summary, Revenue Ruling and Notice certainly provided the industry with much needed guidance regarding partial 1035 exchanges. However, more guidance may still be required, especially if and when regulations are published. For example, if the 24-month distribution rule is enacted, how will companies track distributions from contracts held at different companies? Will there be additional tax reporting requirements? Who will determine if a safe harbor exception is met? What tax reporting requirements will be imposed on companies for safe harbor distributions? Notwithstanding these questions, the issuance of Revenue Ruling and Notice has dramatically changed the way annuity companies can do business. Most companies will likely be updating their systems and procedures in order to provide partial 1035 exchanges. As in any other business, annuity companies are always looking for ways to differentiate themselves. For now, those companies that can accommodate partial 1035 exchanges efficiently and accurately will certainly have a competitive advantage. IRS Revenue Procedure The IRS has changed the way it treats annuity withdrawals that follow a partial exchange of assets from one annuity to another. Under Revenue Procedure , the IRS will reduce the period it considers when deciding whether a taxpayer made a partial exchange to avoid taxes on withdrawals to 12 months, from 24 months under IRS Revenue Procedure (discussed above). In addition to shortening the exchange review period, the IRS also removed the requirement relating to the taxpayer s motives for making the partial annuity exchange. The New IRC Section 1035(a)(4) IRC Section 1035, providing for tax-free exchanges of insurance and annuity contracts, is expanded to allow a life insurance, endowment, or annuity contract to be exchanged for a qualified long-term care insurance policy. The new IRC Section also allows a qualified longterm care insurance policy to be exchanged for another long-term care policy. In addition, under the new IRC Sections 1035(b)(2) and (3), an exchange to or from a life insurance or annuity contract that has a long-term care insurance rider to a policy that does not have such a rider will still be treated as like-kind property for exchange purposes.

16 Partial Annuitization of NQ Annuity Contracts Under H.R. 5297, the Small Business Jobs Act of 2010, signed into law by President Barrack Obama, Section 2113 provides for a partial annuitization provision for non-qualified contracts. The new provision, which becomes effective January 1, 2011, will allow a portion of an annuity, endowment or life insurance contract that is not part of a qualified retirement plan may be annuitized, while the balance is not annuitized, provided that the annuitization period is for 10 years or more, or is for the lives of one or more individuals. If any amount is received as an annuity for a period of 10 years or more, or for the lives of one or more individuals, under any portion of an annuity, endowment or life insurance contract, then that portion of the contract is treated as a separate contract for income tax purposes. The investment in the contract is allocated on a pro rata basis between each portion of the contract from which amounts are received as an annuity and the portion of the contract from which amounts are not received as an annuity. This should simplify the process for non-qualified deferred annuity owners to annuitize a portion of their annuity contract while allowing the remaining amount to grow tax-deferred. Currently, as discussed above, annuity owners can partially annuitize their contracts through a complex process that involves exchanging their annuity contract for two and then annuitizing one of the new contracts. The partial annuitization provision will allow the individual (annuitant) to receive annuity payments from a portion of their contract in one step. IRC 2039: Estate Tax Inclusion Basically, the value of an annuity contract is included in the deceased contract owner s gross estate [IRC 2039]. The value of the contract is determined by federal estate tax valuation rules. When the annuity is owned jointly, the amount included in each owner s estate depends on the marital status of the joint owners. If the joint owners are not married, or if they are married but the surviving spouse is not a U.S. Citizen, the value is included in the estate to the extent of the owner s proportional contribution to the contract purchase. However, when an annuity is jointly owned by a married couple, one-half of the annuity s value is included in the estate of each spouse. This treatment means that estate tax treatment for annuities is different from its treatment of life insurance. In a life insurance policy, it does not matter who paid the premium on a policy. With annuities, payments define the tax treatment at death. The value of the contract is defined as accumulated cash value when the death occurs before payments begin. When death occurs after payments have started, contract value is defined as the present, or commuted, value of remaining contract payments. This contract value can also be defined as the single premium amount that could buy the balance of benefits available in the contract. The insurer that issued the contract supplies this figure.

17 Note that, in terms of estate taxes, it does not matter how the survivor benefits are paid. They may be paid as a lump sum, as an annuity, in period certain installments, or in fixed amount installments. The present value of the remaining annuity payments is included in the gross estate, proportionate to the amount purchased with funds of the decedent. For tax years 2011 and 2012, based on the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, signed into law by President Obama on December 17, 2010, the federal estate tax, gift tax and the generation skipping transfer will be set at a maximum tax rate of 35% with a $5,000,000 exemption. The Act also provides the following provisions: Inherited amounts will receive a full step-up in basis, and 2010 s limited carryover amounts expire. Any unused exemption by one deceased spouse is portable to the second spouse s estate. The executor of the first spouse must actively elect this option on an estate tax return, even if there is no liability owed. IRC 691 (c) Income in Respect of a Decedent (IRD) The IRD deduction [IRC 691 (c)] is one of the oldest provisions in the tax code, dating back to the early 1940 s. With so many baby boomers inheriting larger retirement plans (including nonqualified annuities and IRAs) more people are in a position to qualify for this deduction than ever before. But they may not receive it due to their ignorance of its existence, which is why it is very important for the advisor to understand IRD and to be able to help their clients take advantage of this deduction. Treasury regulations define income in respect of a decedent (IRD) as those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of death or for a previous taxable year under the method of accounting employed by the decedent (Treas. Regs (a)-1(b)). So, with this definition and IRC 691, we are left to identify and administer assets that, upon the owner s death, will produce an immediate ordinary income tax liability to the recipient of the asset. The death benefit of an annuity contract received upon the death of the owner/annuitant is income in respect of a decedent to the extent that the death benefit amount exceeds the basis in the annuity contract. The IRD deduction is a way for the beneficiaries to offset the effect of the double taxation (estate taxation and income taxation) that comes with inheriting assets such as a non-qualified annuity. Note: The deduction only applies to federal income and federal estate taxes. The IRD deduction is much more valuable than most other itemized deductions because it is not eroded by the 2 percent of adjusted gross income (AGI) limitation nor is it even subject to the

18 dreaded alternative minimum tax (AMT). By not checking to see if your clients can qualify for this deduction, it could end up costing them as much as 60 to 70 percent of the inherited annuity. Calculating the IRD Deduction: To calculate the IRD you need to take the following steps: Step 1. Take the federal estate tax amount from page one of IRS Form 706. Step 2. Calculate the estate tax again without including any of the IRD items in the estate. (Note: Subtract out the cost basis of the annuity) Step 3. Subtract the estate tax in Step 2 from the estate tax in Step 1. The result is the total amount of the IRD deduction. Step 4. Divide the amount from Step 3 by the amount of the Annuity value minus the cost basis. This will give you the percentage of the deduction the client will be able to claim. Step 5. Multiply the amount of the distribution (if any) by the percentage from Step 4 to get the deduction amount for the year. Note: There is no place on the IRS forms to guide your clients through the IRD calculation. Without your guidance your client is more likely to miss this important tax opportunity. You should educate your clients on what IRD is and encourage them to speak to their tax accountant and/or attorney to help calculate the deduction. State Premium Taxes Some states impose a State Premium Tax against either the Accumulated Value of the annuity policy or the Purchase Payments. Companies deduct these taxes as incurred according to state regulations. State tax laws change, check with the company issuing the annuity contract for the most current tax status. State Premium Taxes as of December 1, 2004 State Qualified Funds Non-Qualified Funds South Dakota* 1.25% *Assess a premium tax against the initial premium payment and all additional premium payments. California**.50% 2.35% Maine** 2.00% Nevada** 1.00% 3.50% Virgin Islands** 5.00% West Virginia** 1.00% Wyoming** 1.00% **Assess a Premium Tax against the Accumulated Values when the Owner chooses an Annuity Payment Option.

19 Disclaimers With Regards to Tax and Legal Issues The financial advisor/insurance professional should make every effort to assure the client that they are not giving tax or legal advice. Review disclaimers below: If a financial advisor/insurance professional offers to sell to a client any life insurance or annuity product, the life agent shall advise the client or the client s agent in writing that the sale or liquidation of this product may have tax consequences. The financial advisor/insurance professional shall disclose that the client may wish to consult independent legal counsel for financial advice before buying, selling or liquidating any assets being solicited or offered for sale. This course is not intended to provide advice with issues surrounding income and estate taxation of annuities. If expert tax assistance is required, financial advisor/insurance professional shall advise client to consult with other professionals. About the Author: Edward J. Barrett CFP, ChFC, CLU, CEBS, RPA, CRPC, began his career in the financial and insurance services back in 1978 with IDS Financial Services, becoming a leading financial Advisor and top district sales manager in Boston, Massachusetts. Mr. Barrett is a qualifying member of the Million Dollar Round Table, Qualifying Member Court of the Table and Top of the Table producer. He holds the Certified Financial Planner designation CFP, Chartered Financial Consultant (ChFC), Chartered Life Underwriter (CLU), Certified Employee Benefit Specialist (CEBS), Retirement Planning Associate (RPA), and the Certified Retirement Planning Consultant (CRPC).