There are many types of annuities, each with its own set of rules. This article discusses commercial annuities. This article discusses how an annuity works and then explains the tax treatment.
How Commercial Annuities Work
The “purchaser” buys the annuity from the “seller,” say, an insurance company. The “owner” or “holder” owns the annuity policy. The “annuitant” receives the annuity payment and provides the measuring life for the term of the payments, if necessary. The purchaser, owner, and annuitant may all be the same person. The “beneficiary” receives the remaining benefits at the annuitant’s death.
The purchaser pays one or more premiums in exchange for the insurance company’s promise to pay the annuitant a sum of money periodically, beginning at some date in the future or an annuity period. The “annuity period” is generally a term of years, or the life of one or two people, or the life expectancy of one or two people, or a combination of these. The “annuity starting date” is the first day of the first period for which an amount is received as an annuity.
For example, an annuity is payable for each full calendar year at the end of the year. If the annuity begins in 2025, the annuity starting date is January 1, 2024. The first payment will be made on December 31, 2024.
The annuity starting date may be immediate or deferred. The starting date of a deferred annuity will usually be a date occurring after the annuitant attains 59 1/2 (or the annuitant’s earlier disability or death), since earlier distribution will cause a ten percent penalty unless certain special exceptions apply. If the annuitant dies before the annuity starting date, a death benefit is paid which is typically the greater of the premiums paid or the accumulation value of the contract. If the contract is surrendered during the first few years after it is purchased, there is usually a surrender charge imposed by the insurance company.
The insurance company credits the premiums paid with earnings. These earnings result in income on the contract. If the holder is a natural person, the income on the contract each year is not subject to income taxation, except to the extent it is received by the annuitant, holder, or beneficiary, or until the contract is transferred by the holder. “Income on the contract in any year is the cash value of the policy (determined without regard to surrender charges) plus all distributions ever received under the contract, less the sum of the net premiums paid for all years and all amounts included in gross income for prior years. See IRC Sections 72(u)(2), 72(e)(3)(A). Income on the contract is analogous to the concept of unrealized appreciation.
For purposes of this article, the “cash value” of the contract at any time is the amount of the cash the holder will receive if he or she surrenders the contract, without subtracting any surrender charge.
The “investment in the contract” is a concept comparable to the “basis” of other assets. Thus, it is the amount that has been paid for the contract, reduced by amounts previously received which were excludable from income.
Below, please see Illustration 1 which demonstrates a typical investment contract.
Illustration 1.
Assume that Sue has paid $100,000 of annuity premiums. She has received one distribution of $5,000; $3,000 of that distribution was treated as a return of principal. If no special rules apply, Sue’s investment in the contract (or basis in the policy) is $97,000.
While the original owner’s initial investment in the contract will generally consist of premiums paid, a successor owner computes his or her initial investment in the contract as follows:
Purchased contact. If Child purchases an annuity contract from Mom, Child’s initial investment in the contract is the consideration he pays.
Gifted contract. If Mom gives an annuity contract to Child, Child’s initial investment in the contract is the same as Mom’s investment in the contract, plus any income recognized by Mom on the transfer.
Contract acquired from decedent. If Mom dies holding an annuity contract, and Child receives the contract as a result of Mom’s death, Child’s initial investment in the contract is Mom’s investment in the contract; i.s., no change in basis occurs on Mom’s death.
Amounts received as an annuity are taxed under the annuity rules of Section. “Amounts received as an annuity” are amounts which are payable at regular intervals over a period of more than one full year from the data on which they are deemed to begin, provided that either the total amount payable or the period over which the payments may be paid can be determined as of that date. See IRC Section 72(e)(4)(C)(iii).
For purposes of this article, we will call any amount received under the contract that is not an amount received as an annuity, a “non-annuity distribution.” Non-annuity distributions with respect to contracts include loans, dividends, cash withdrawals, and amounts received on partial surrender of a contract. Additionally, a transfer of an annuity contract for less than adequate consideration will generally result in a deemed taxable distribution.
Kinds of Commercial Annuities
The purchaser of an annuity has a number of structural choices. They are as follows.
Fixed annuities. These annuities offer a guaranteed interest rate and payout, so the income is typically not affected by market volatility.
Variable annuities. These annuities allow the annuitant to allocate more among a range of market-based investment options, which can provide growth potential. Like an ordinary or fixed annuity, a variable annuity is also a contract to pay an amount to the annuitant at periodic intervals. However, the premiums paid for a variable annuity will be deposited in a separate account for the owner. The amount or other benefits will depend on the performance of the investments in the account. The owner can direct those investments, usually by choosing among various funds offered by the insurance company. Unlike an ordinary annuity, a variable annuity is not backed by the insurance company’s general assets. Instead, its payment depends solely on the performance of the fund.
Immediate annuities. These annuities convert a lump sum of money into cash flows that begin after the purchase of the annuity. An immediate annuity contract is usually purchased with a single premium. The annuity starting date is one year or less from the date of purchase. The contract provides for a series of substantially equal periodic payments to be made at least annually during the period.
Qualified annuities. These annuities are used to invest and disburse money in a tax-favored retirement plan.
Non-qualified annuities. These annuities are funded with after-tax dollars, and the annuitant pays tax on the earnings and interest portion of the distribution.
Ordinary or Variable Annuities
An “ordinary annuity” is a promise to pay a fixed amount periodically for the annuity period.
Below, please see Illustration 2 which demonstrates an ordinary annuity.
Illustration 2.
Tom buys an ordinary annuity from the Insurance Company. He pays Insurance Company a lump sum premium of $100,000, and the company agrees to pay him $1,000 a month for life.
The fixed amount may vary with time or a specific economic indicator (e.g., it may increase by a certain percentage each year, or it may vary with increases in a specific stock market index). However, the amount does not vary based on the performance of particular assets in which the insurance company has invested the premium payments. The insurance company’s obligation to make payments is backed by the insurance company’s general assets. If the insurance company fails, the holder may lose his or her investment.
Most annuities purchased as investments or for retirement are deferred annuities. A deferred annuity is any annuity that is not an immediate annuity. Below, please see Illustration 3 which demonstrates a typical deferred annuity.
Illustration 3.
Bob buys a deferred annuity from Insurance Company. He pays Insurance Company $100,000, and the company agrees to pay him $10,000 a year beginning on his 65th birthday.
Pricing of Annuities
There are two parts of the cost of an annuity: 1) the initial premiums and 2) the annual charge levied by the insurance company. The annual charge will affect the surrender value of the annuity and the amount of premiums needed to keep it in force. The value of an annuity will generally increase with the interest rates. When interest rates decline, the opposite will occur. Another factor that can affect the price and value of the relationship of an ordinary annuity is the financial health of the insurance company. Besides the annual charge, an annuity contract usually also provides for a surrender charge of a percentage of the surrender value if the annuity is surrendered in the first several years.
Income Taxation of Annuities
In the case of an annuity held by an individual, the income on the annuity contract is not generally taxed until distributions are made. However, when annuity distributions are made, the distributions are taxed as ordinary income.
The value of a deferred annuity contract may increase with time. The resulting income on the contract is not generally taxable on a current basis if the contract is held by a natural person. Therefore, if no distributions are made from the contract prior to commencement of the annuity, no income tax should be owed until that time. This tax deferral represents the tax advantage of the investment. Internal Revenue Code Section 72(u)(1) provides that if a non-natural person (i.e., an annuity) holds a deferred annuity other than as an agent for a natural person, the income on the contract each year will be taxable to the holder as ordinary income, unless the contract is acquired by the estate of a decedent because of the decedent’s death or the contract is an immediate annuity. While a non-natural person is any entity, it should not include a revocable trust or other grantor trust since such trusts are deemed owned by the grantor for income tax purposes
Non- Annuity Distributions
The taxation of a non-annuity distribution depends on whether it is made before or after the annuity starting date. A non-annuity made before the annuity starting date is taxable as ordinary income to the extent of income on earnings. To the extent that such a non-annuity distribution exceeds the income on the contract, it will be treated as a tax-free return of cost.
Taxation of Annuity Payments
Each payment received consists of a nontaxable portion and a taxable portion. The nontaxable portion is the exclusion ratio multiplied by the payment amount. The balance of the payment is taxable as ordinary income. For example, if Mom purchases an annuity contract measured by her life in 2026 and invests a total of $40,000 in the contract. The expected return on the contract (determined by the IRS tables) is $120,000. Mom’s exclusion ratio is $40,000 divided by $120,000 or ⅓. If Mom receives annual payments of $3,000, she should include $2,000 inheritance gross income each year.
Some contracts guarantee that an annuity will be paid for certain term of years, or provide that if the annuitant dies before distributions totaling a certain guaranteed amount have been made, the beneficiary will receive a distribution in the nature of a “refund” of the difference between the guaranteed amount and the amount of payments actually made. The investment in the contract for such an arrangement is reduced by the present value of the refund for purposes of determining the tax on distributions.
The beneficiary of an annuity with a refund feature receives all non-annuity distributions tax-free as a recovery of cost until the investment in the contract is recovered (including the excludable amounts received by the annuitant). Distributions exceeding that amount are taxed as ordinary income. If the beneficiary receives the benefits as annuity payments, he or she will be taxed under the annuity rules. If the annuity is a joint and survivor annuity, the survivor excludes from the income the same percentage of each payment that was excludable before the first annuitant’s death, until the total exclusion by both annuitants equals the investment in the contract.
Conclusion
Annuities can provide a steady income for retirement, which can help people avoid outliving their assets. Annuities should be considered as part of any retirement planning.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
