David's Latest Blog

The Problem with  Annuities....


Part 1.  Many tax professionals don’t like traditional deferred  annuities due to their income tax treatment. When non qualified account values are accessed, any gains in the contract are deemed to be withdrawn first, called “Last in, First out” or “LIFO”. This means that if there are substantial deferred gains in the contract, the client will pay ordinary income taxes on the withdrawl of such funds until those gains have been fully withdrawn. Also, if the contract owner is under age 59 ½, under most circumstances, the withdrawl of those gains will also rusult in a 10% tax penalty on top of ordinary income taxes. So, the question becomes…is there any way to tax defer non qualified investments and still avoid those pesky penalties? Yes, there is…read more.


Part 2.   Under Internal Revenue Code section Rule 72(u)(4), immediate annuities have a totally different tax treatment than deferred annuities.  Most immediate annuity contracts, however, deal with payout only, and have no accessible cash value.  What if there was a contract that did have cash value?  How would it be different than the typical deferred annuity? 

Well, one way it can benefit is when an annuity is inherited.  Typically, a beneficiary, a child for example, has only two choices when a non-qualified deferred annuity is inherited.  Either show the deferred gains as ordinary income on their income tax returns in the year received (typically the year of death of the contract owner/annuitant) or take the values over the course of 5 years, again, receiving gain proportionately over the 5 year period using a very low rate of return in the immediate annuity payout. 

However, an immediate annuity with a cash value behaves differently.  If the original owner was taking an immediate annuity payout prior to death, then the cash value of the inherited contract can withdrawn, the cost basis of the values first, tax free; then leave the remaining gains in the contract under a life income payout, spreading the gains of the contract over their life expectancy.  That is a great difference. 

In future blogs, I will outline other scenarios where this differing tax treatment is a huge benefit.


Part 3.  Case Study:  Under Internal Revenue Code section Rule 72(u)(4), immediate  annuities can solve various problems. For example, a 101 year old client had purchased a typical deferred annuity at age 88 (not too many choices at that age!).  At age 101 it was worth $208,000 and had a cost basis of $140,000.  Under the contract, it was to expire at his age 102. This was going to force a lump sum distribution and cause him to realize $68,000 in additional ordinary income in the year distributed.  Hmmm, problem.  He owned it and was the annuitant.  The company would allow him to change the annuitant to his son, aged 68.  Once this was accomplished, he changed ownership of the contract to his Revocable Living Trust, which was under his tax id number.  Once that was accomplished, the contract could be exchanged under the 1035 exchange rules with a contract owned by his trust with his son as annuitant.  Using a immediate annuity product with cash values (there are only a few out there….) the client started immediate income based on the son’s age 68 (a lower distribution rate than would be based on an older age).  This avoided the forced lump sum distribution, and when the client passed away 6 months later, his son continued the contract without the  estate (and thus his son and grandson, as beneficiaries of the trust estate) incurring $68,000 of ordinary income.  Instead, the son has a tax deffered asset of over $200,000 and has a relatively low taxable income stream from the contract for his lifetime.