Taxation of Annuities
A qualified or non-qualified annuity receives tax deferral during the accumulation phase or period. The accumulation phase may terminate if the contract owner is disabled or dies and then the annuity phase commences. Contributions to qualified individual or employer-sponsored annuity are generally tax deductible. However, contributions to or premiums paid for a non-qualified individual annuity are not tax deductible. The cost basis of an annuity is generally the amounts contributed (premium paid) by the contract owner. Penalties are assessed on premature distributions except if the owner becomes disabled, the owner has reached age 59 and half, the owner had died, an immediate annuity was purchased or funds are received under a qualified period plan. If lump sum cash surrender is affected when the contract owner dies during the accumulation phase, any amount received in excess of the payments made to the contract is taxable. Also, assume the owner invests a specific amount into the contract let say $15,000 and several years later the contract value is higher due to interest credited $22,000.IF he or she withdraws $10,000 from the account, the interest or $7,000 will be taxable. Withdrawn amounts are generally taxed on Last in first out basis which means that accumulations or interest earned is considered withdrawn first when distributions are made.
The beneficiary is also able to minimize tax liability, for instance, if he or she elects a life income option or an installment option based upon the exclusion ratio. However, he choice must be made within 60 days of the annuitant contract owner’s death. When the annuity phase commences, each payment (benefit) is comprised of non-taxable return of principal and taxable return of interest. To determine what is taxable, an exclusion ratio is utilized. This is the ratio of the total investment in the contract to the expected return and gain it determines the portion of the payment that will be non-taxable and the portion that will be taxable.
If the owner dies during the accumulation phase and prior to the annuity phase, the beneficiary will receive the greater of the accumulated value of the annuity or the amount of contribution. Any amounts received in exceeds of premiums paid are taxable as ordinary income to the recipient. Therefore, whatever gain is realized will be taxable. The annuity must also provide that if the owner dies prior to the annuity phase, the entire interest in the contract must be distributed within five years following the owner’s death. If the beneficiary chooses to annuitize the contract proceeds within one year of the owner’s death, the Internal Revenue Service considers the five-year distribution requirement satisfied. The amount paid to the beneficiary when the contract owner dies is the amount accumulated. The death benefit paid by life insurance is the face amount no matter how few premiums have been paid. Since an annuity is a price of property, if the contract owner/annuitant dies during the accumulation period, its proceeds are generally included in the deceased’s estate.
Corporate Annuity tax
Contributions to a corporate annuity are taxed differently than individually owned annuities. If the corporate owned annuity qualifies as a tax retirement plan, it will be taxed differently. Prior to 1986, interest earned in an annuity was deferred regardless of whether an individual or corporation owned the contract. The federal government then enacted legislation designed to prevent corporations and other entities from taking advantage of the tax deferral provisions of the tax code. Current tax law states that if a corporation owns an annuity it must name natural person as an annuitant. Sometimes this natural person is referred to as a measurable life. If a natural person is named as annuitant, the interest credited to the annuity each year is generally not taxable. If a non-natural entity is named an annuitant the corporation, interest earned is taxable as ordinary income in the year credited. There is an exception to this non-natural person rule. If the annuity is held by a trust, corporation, or other non-natural person, as an agent for a natural person, interest earned continues to be tax deferred. Other exceptions to this rule include but are not limited to An annuity contract that is acquired by a person’s estate following the death of that person; an annuity contract that is held under a qualified retirement plan, a TSA or an IRA or a contract which is an immediate annuity purchased with a single premium, with periodic payments to commence within a year.
Corporate owned life insurance is generally treated as a deductible business expense. The proceeds are paid tax free up to a certain level $50,000. If more than this amount is provided to an employee, the excess premium used to purchase it must be reported by the employee as taxable income. An annuity could also be owned by a nonliving entity such as a trust and the tax considerations will be based upon whether it is qualified or non-qualified.