11/7/2011
Tax Traps In Annuity Planning Presented to the
Financial Planning Association by John L. Olsen, CLU, ChFC, AEP Olsen Financial Group November, 2011
(c) John L. Olsen, 2011
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What we’ll be doing in this session… • Examining taxation of annuities • Reviewing the basics • Focusing on lesser-known issues • Identifying “land mines” • When annuitant and owner are different parties • When an annuity is owned by a “non-natural person” • When an annuity is payable to a “non-natural person” • Jointly held annuities • Transfer of an annuity (c) John L. Olsen, 2011
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What we’ll be doing in this session… (Cont’d) • Considering annuity death benefits • Whose death triggers the benefit? • Which death benefit is triggered? • What are beneficiary’s options?
(c) John L. Olsen, 2011
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But first, a review of the basics… • What is an annuity? • Classification: 2 Dichotomies: • When Income Begins (immediate vs. deferred) • How money is invested (fixed vs. variable) • What are Index annuities?
(c) John L. Olsen, 2011
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Parties To The Contract • Issuer • Owner • Beneficiary • Will receive proceeds on death of ..whom? • It depends on whose death “drives” the death benefit, and… • That factor determines which death benefit is payable
• Annuitant • Only the “measuring life” • May not be payee of annuity income payments • Where annuitant and owner are different parties, there’s potential for real trouble (c) John L. Olsen, 2011
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Tax Aspects of Annuities •
Income Taxation During Lifetime •
Distributions (whether made during lifetime or after death) are either 1. “amounts received as an annuity” or 2. “amounts not received as an annuity”
(c) John L. Olsen, 2011
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Income Taxation During Lifetime (Cont’d) • “Amounts Received As An Annuity” • • • •
If fixed annuity, exclusion ratio applies If variable annuity, slightly different Will this treatment apply for life? If ASD was after 12/31/86, ratio applies only until basis is recovered
(c) John L. Olsen, 2011
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Income Taxation During Lifetime (Cont’d) • “Amounts Not Received As An Annuity” ( 72(e)) • Contracts issued after 8/13/82 = “Interest First” • “Received” includes withdrawals, loans, and amounts • • • • •
pledged as collateral ( 72(e)(4)(A) Sale of the annuity Gift of annuity issued after 4/22/87 Gift of annuity issued before 4/23/87 Gift to Spouse not taxable ( 72(e)(4)(C)) Gift to Charity • Triggers recognition of gain (current law) • Donor may take deduction, but subject to 50%/30% of AGI limitation
• Gift of annuity to transferor’s irrevocable grantor trust (c) John L. Olsen, 2011
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Income Taxation During Lifetime (Cont’d) “Amounts Not Received As An Annuity” (Cont’d) • Contracts issued before 8/14/82 = “Principal First” • Applies only to amounts allocable to investments made before 8/14/82
(c) John L. Olsen, 2011
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What Code Section Grants Tax Deferral of Gain In A Deferred Annuity? • No section specifically grants such deferral. • It’s granted by implication.
(c) John L. Olsen, 2011
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Income Taxation During Lifetime (Cont’d) • Q: When does gain in an annuity not receive tax deferral? • A: When held by “other than a natural person”, it’s not an “annuity” (IRC 72(u)) (to extent of contributions made after 2/28/86) • Exceptions: • • • • •
Qualified contracts “Qualified funding asset” Immediate annuities Contracts acquired by estate due to death Where holder is “agent of a natural person” (IRC 72(u)(1)) 11
(c) John L. Olsen, 2011
Income Taxation During Lifetime (Cont’d) • Early Distribution Penalty (IRC
72(q))
• Applies only to amounts that would be includible in income • Exceptions • • • • • • • •
Made after taxpayer’s age 59 ½ Made by reason of death of holder Taxpayer’s becoming disabled S.E.P.P. Qualified Plan or IRA Allocable to investment made before 8/14/82 Under a “Qualified Funding Asset” Immediate Annuity (c) John L. Olsen, 2011
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Income Taxation During Lifetime (Cont’d) • Whose tax is it? • What about a LOSS incurred in a deferred annuity? • What about “rescuing basis” of a life policy by exchanging it for a deferred annuity and surrendering the annuity?
(c) John L. Olsen, 2011
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Income Taxation During Lifetime (Cont’d) • Q: What is effect of Surrender Charges on taxability of surrendered deferred annuity? • A: It depends on whom you ask. • TP buys SPDA for $100k. 3 yrs later, it has a CV of $110k, subject to a $10k surrender charge. • TP surrenders contract for $100k at that point. • What is taxable gain, if any? • PLR 200030013; TF (2011) Q. 3539 (c) John L. Olsen, 2011
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Income Taxation At Death IRC 72(s) • .When contract was in “payout status” • Must be distributed to beneficiary “at least as rapidly as” owner was taking ( 72(s)(1)(A) • Change in tax treatment. Distributions to beneficiary not taxable until basis recovered (including payments made to owner/annuitant) ( 72(b)(4))
• Thus, “Regular annuity rules” don’t apply - unless beneficiary elects new annuity option (Treas. Reg. IRC Sec. 72(e)(5)(E); Treas. Regs. 1.72-11(c), 1.7211(e))
(c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d) • When contract was not in “payout status” (not annuitized) • Lots of confusion • Not in how taxable amounts shall be determined, but .. • In how and when benefits must be distributed to beneficiary
• First source of confusion is…
(c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d) • When are death benefits payable? • Whose death triggers payment of which death benefit? • Two kinds of Deferred Annuity contracts: • “Annuitant-Driven” • “Owner-Driven” • ALL contracts issued since 1/18/85 are “Owner-Driven” • SOME are ALSO “annuitant-driven” (c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d) • Why is this distinction important? • Identity of decedent determines which death benefit will be paid • “Owner-driven” contract. Death of owner will trigger guaranteed death benefit • “Annuitant-driven” contract. Death of annuitant will trigger guaranteed death benefit. Death of owner will trigger payment of annuity account value. (c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d) • None of this matters, so long as owner and annuitant are the same individual. • But what if they’re not?
(c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d): When Owner and Annuitant are different parties • Owner’s death will always trigger payment of some death benefit. • What if contract is not annuitant-driven and annuitant dies? • Generally, nothing. Owner names new annuitant.
• What if contract is annuitant-driven and the non-annuitant owner dies? • It depends upon contract language. • One contract will pay to owner’s estate! (c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d) • Annuitant-driven contract. George is owner. Gracie is annuitant. Gracie dies. What happens? • Who is the beneficiary? • If it’s George, he cannot do “spousal continuation” • But what if it’s a third party?
• Somebody could get sued!
(c) John L. Olsen, 2011
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Income Taxation At Death (Cont’d) • What about Joint Ownership? • Will surviving owner become owner? • Some carriers’’ “spousal continuation” language when Jointly Owned • Why do Joint Ownership in the first place?
• You’ve got to Read The Contract!
(c) John L. Olsen, 2011
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Annuities And Trusts • This area is a real mine field!
(c) John L. Olsen, 2011
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Annuities And Trusts (Cont’d) • Annuity Owned By Trust • NQ Annuity Owned By Owner’s RLT • Where’s the Benefit? • 72(u)(1) – Is Trust the “agent of a natural person”? • Primary Annuitant deemed to be “holder” ( 72(S)(6)(A)) • Deferred annuity owned by George’s irrevocable grantor trust. Daughter Sally is annuitant. Whose death triggers distribution?
(c) John L. Olsen, 2011
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Annuities And Trusts (Cont’d) • Annuity Payable To Trust • NQ Annuity Payable To Owner’s RLT • George and Gracie • Gracie is beneficiary of George’s annuity. George dies. What are Gracie’s options? • • • •
Lump Sum Within Five Years ( 72(s)(1)(B)) May Take As Annuity ( 72(s)(2)) May treat annuity as her own, ab initio ( 72(s)(3))
• George’s RLT is named beneficiary. What are payout options at George’s death?
(c) John L. Olsen, 2011
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Gracie loses the last two options! This is probably true, even if Gracie is Sole Trustee and Sole Beneficiary of that Trust!
(c) John L. Olsen, 2011
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What Lessons Can We Learn From All This? • Read the annuity contract! • Understand that an annuity is a tool, not a magic bullet • Don’t make annuitant and owner different parties without a good reason • Don’t make annuity payable to a Trust without a good reason • Don’t name Joint Owners without a good reason • Be aware of “triggers” on taxation on gain (gifting, pledging as collateral) (c) John L. Olsen, 2011
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For More Information… • • •
• •
Olsen, John L., CLU, ChFC, AEP & Kitces, Michael E., CLU, ChFC, MSFS, CFP®, The Annuity Advisor (National Underwriter Co., 2nd, ed, 2009) Olsen, John L., CLU, ChFC, AEP & Marrion, Jack, Index Annuities: A Suitable Approach (Olsen & Marrion, LLC, 2011, www.indexannuitybook.com) Olsen, John L., CLU, ChFC, AEP, • “Making Sense of Annuity Taxation: A Q&A With John Olsen”, Journal of Financial Planning, April, 2010 • “Tax Mines in Annuity Taxation”, InsuranceNewsNet, November, 2010 • “Annuities and Suitability: Reflections on the State of the Debate”, Journal of Financial Service Professionals, November, 2006 • Annuity Taxation and Suitability – to be published by Olsen & Marrion, LLC in early 2012. Tannahill, Bruce A., “Are Nonqualified Annuities Trust-Worthy? Avoiding Tax Traps When A Trust Owns Or Is Beneficiary Of A Nonqualified Annuity”, Probate & Property, Vol. 20, Number 4 (July-August, 2006) Underwood, J. Gary, “Trust Ownership of Nonqualified Annuities: General Consideration for Trustees”, Journal of Financial Service Professionals, May, 2010 (c) John L. Olsen, 2011
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Questions? John L. Olsen, CLU, ChFC,AEP Olsen Financial Group 131 Hollywood Lane Kirkwood, MO 63122 314-909-8818
[email protected] (c) John L. Olsen, 2011
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