Tax rules governing certain annuity transactions
While annuities are fairly basic in how they’re purchased and what they’re used for, they provide several complex tax scenarios. Certain transactions involving annuities can trigger taxable events and/or tax penalties, which can catch people off guard if they don’t fully understand these rules.
Here is a list of some common scenarios in which annuities generally lose their tax advantages or are treated differently for tax purposes.
Exceptions to the 10 percent tax penalty. The 10 percent penalty tax generally applies to the taxable amount of distributions from annuities made before the owner reaches age 59½. Exceptions to this rule include:
- Distributions or surrender made as a result of the owner’s death or disability.
- Distributions 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
- Immediate annuity distributions
- Annuities purchased before August 14, 1982
Transfer of ownership. If an individual transfers ownership of a non-qualified annuity, 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 those made to a former spouse as the result of a divorce decree). 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. An exception to this rule is an annuity bought before April 22, 1987, in which the earnings in the contract can continue to be deferred, with the old cost basis carried over to the new owner.
Gifting an annuity. An annuity gifted to another party triggers a taxable event to the donor. Capital gains will be taxed at the current owner’s tax bracket. If the gift occurs prior to the annuity owner turning 59 1/2, the transaction will be subject to a 10 percent early withdrawal tax penalty.
Estate tax. The total value of the contract is subject to estate tax upon the owner’s death, not just its cost basis.
Taking a lump sum on an annuity that has lost value. If you own a variable annuity that has sunk in value since you purchased it, then you may be able to claim the loss as a deduction on your tax return, as you would any other depreciating asset. The deduction would be the amount you surrendered the annuity for minus your cost basis, or what you paid into the contract. If you surrender an annuity that’s still within its surrender charge period, you cannot take a deduction for the surrender charge assessed.
Trust-owned annuities. There is some discrepancy regarding whether trust-owned annuities enjoy the same tax-deferral growth as annuities owned by people. The Internal Revenue Code states that annuities owned by entities such as corporations and trusts must pay tax on annual gains within the annuity. However, a trust-owned annuity can maintain its tax-deferral status as long as the “beneficial owner” is a person. So if a trust owns an annuity that benefits, for example, a surviving child, then it should grow tax deferred. If the trust funds are held by a business partnership, the annuity owned by the trust loses its tax deferral.
Aggregation rules. The IRS treats multiple annuity purchases from a single insurance company within the same calendar year as a single transaction for tax purposes. This is referred to as aggregation. This rule is designed to prevent owners from manipulating the basis in each individual contract. Exceptions to this rule include:
- Contracts purchased from different insurance companies
- If the purchase includes one deferred annuity and one immediate annuity
- Deferred annuity contracts that are exchanged into immediate annuities
- Distributions required on account of the death of the owner
- Contracts issued prior to October 21, 1988
Listing annuities as collateral. When you use all or part of your annuity as collateral for a loan, it is treated as if it’s been surrendered and applicable taxes will be assessed. If this is done before the owner turns 59 1/2, it also incurs the 10 percent early withdrawal penalty. If the entire contract is assigned or pledged, additional interest credited to the contract is considered additional partial withdrawals and will be taxed as such.