1. TAX TRAPS IN ANNUITY PLANNING
An Insider’s Guide
The seminar will begin promptly at 2:00 p.m.
Slides will be provided after the seminar.
This seminar is being recorded.

2. FEATURED SPEAKERS: John Olsen, CLU, ChFC, AEP
Olsen Financial Group
131 Hollywood Lane
Kirkwood, Missouri
Robert Bloink, J.D., LL.M.
HBC Ferguson, PLLC

3. (Tax Facts Questions 353 and 359)
How are income payments received pursuant to an annuity contract usually taxed?
(Tax Facts Questions 353 and 359)
All Distributions from any annuity are either “amounts received as an annuity” or “amount not received as an annuity” next 2 slides deal with these

4. “AMOUNTS RECEIVED AS AN ANNUITY”
(IRC §72(b), Tax Facts Questions 359, 361, 363)
Amounts received as an annuity are taxed under an EXCLUSION REGIME, where a part of each annuity payment is considered a return of principal.
When is this treatment available? When the contract has been ANNUITIZED. The method of calculating the exclusion is different for variable vs
Fixed annuities.
Non-variable – exclusion ratio is total investment in contract / total expected return
Variable – excludible portion = investment in contract / no. of years of payout (cost basis is recovered pro rata over payout period)

5. “AMOUNTS NOT RECEIVED AS AN ANNUITY”
(IRC §72(e), Tax Facts Question 355)
Tax treatment depends upon when contract was issued
ISSUED AFTER 8/13/82 – “INTEREST FIRST”
Issued BEFORE 8/14/82 – “PRINCIPAL FIRST”
Contracts acquired in exchange for pre-8/14/82 contracts GENERALLY grandfathered with respect to amounts allocable to premiums paid before 8/14/82

6. How is the beneficiary taxed on these payments?
If the owner of an annuity contract dies before a deferred annuity contract is annuitized, how must the contract be distributed?
How is the beneficiary taxed on these payments?
Is anything included in the decedent’s estate?
(Tax Facts Q 396, 397)
If death occurs prior to annuity starting date, all gain is taxable as IRD to beneficiary, who may take itemized deduction for
FEDERAL estate tax attributable to that gain (IRC 69(c))
Entire value of annuity contract is taxed in estate of holder.
CONTRACT VALUE MUST BE PAID OUT PER SECT.72(s).
5 YR DEFAULT RULE
ANNUITIZATION IF PAYBLE TO DESIGNATED BENEFICIARY
SPOUSAL CONTINUATION EXCEPTION
CONFUSION RE: 72(h) and 72(s) requirements. What does 72(h) really require?

7. What are the tax consequences if an annuity owner takes the annuity proceeds in a lump sum payment instead of receiving periodic payments under the annuity contract? (Q393)
Some insurers misread IRC 72(e)(3) as requiring that gain on surrender be calculated without regard to surrender charges. GIVE EXAMPLE. This is incorrect, as IRC 72(e)(5) states that in cases of full surrender, that “without regard to” rule of 72(e)(3) doesn’t apply. However, the “without regard to surrender charge” DOES apply in cases of PARTIAL surrender.
THIS IS DISCUSSED BOTH IN TAX FACTS AND, EXTENSIVELY, IN “THE ANNUITY ADVISOR”

8. If the owner exchanges one annuity contract for another, how is that exchange taxed? (Q383)
Full exchange Q383. MUST be done via absolute assignment
Partial exchange – Q383 outdated. Rev.Proc If no withdrawals from either contract within 180 days of exchange, pro-rata allocation of basis. No 72(q) event reference.See Advisors Guide to Annuities, chapter 3.

9. How is the owner of a deferred annuity taxed on the growth of the annuity during the accumulation period?
Is the full amount of the gain taxed when the contract matures? (Q373, Q395)
Tax deferral of gain. No specific code section grants it. All gain taxed in year of surrender unless election to take as annuity within 60 days (72)h)).
Yes, full amount of gain is taxable at MATURITY. Explain “maturity extension”.

10. Are there any penalties if distributions are taken on an annuity contract prematurely?
What if the owner of a deferred annuity exchanges it for an immediate annuity? (Q356)
72(q) from ADVISOR’S GUIDE TO ANNUITIES -
(A) made on or after the date on which the taxpayer attains age 59½;[i]
(B) made on or after the death of the holder (or, where the holder is not an individual, the death of the primary annuitant);
(C) attributable to the taxpayer becoming disabled;[ii]
(D) which are a part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and his designated beneficiary;[iii]
(E) from a qualified pension, profit sharing, or stock bonus plan, Section 403(b) annuity plan, or IRA;
(F) allocable to investment in the contract before August 14, 1982;[iv]
(G) under a qualified funding asset;
(H) subject to the 10% penalty for withdrawals from a qualified retirement plan;[v]
(I) under an immediate annuity contract; NOTE THAT ISSUE DATE OF ORIG DEFERRED CONTRACT CONTROLS!
(J) which are purchased by an employer upon the termination of a qualified plan and which is held by the employer until such time as the employee separates from service.
[i]. In the authors’ opinion, “Taxpayer,” here, refers to the taxpayer responsible for paying the tax on a distribution. If A, age 81, owns an annuity of which B, age 55, is annuitant, and requests a withdrawal, that withdrawal is not subject to the 10% penalty because A, as owner of the contract, is liable for tax on the distribution, even if the distribution is made directly to B, at A’s direction.
[ii]. “Disabled” is defined in Section 72(m)(7), which states: “[F]or purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.”
[iii]. Under IRS Notice , IRB 526, taxpayers seeking substantially equal periodic payments from annuities under Section 72(q)(2)(D), may rely on the guidance of IRS Notice CB 662 (as modified by Revenue Ruling , CB 710), which provides explanation and rules regarding substantially equal periodic payments from retirement accounts under Section 72(t).
[iv]. This provision is actually somewhat redundant. Section 72(q)(1) already indicates that the penalty will apply only to amounts includable in gross income, and Section 72(e)(5) already indicates that withdrawals allocable to investment in the contract before August 14th, 1982 will not be included in income (and thus could not be subject to penalty).
[v]. This prevents the imposition of a Section 72(q)(1) early withdrawal penalty on a “qualified” annuity that is already subject to the early withdrawal penalty rules under Section 72(t).

11. ANNUITY OWNERSHIP ISSUES

12. What are advantages and disadvantages of joint OWNERSHIP of a deferred annuity?
What are the advantages and disadvantages of purchasing a joint and survivor annuity rather than simply naming the second party as a beneficiary?
What are the tax consequences to a surviving annuitant under a joint and survivor annuity? (Q369)
JOINT OWNERSHIP: What’s gained? GIVE EXAMPLE
A Joint and Survivor annuity guarantees that an INCOME STREAM of stated value WILL be paid so long as EITHER annuitant lives.
By contrast, a beneficiary designation passes only that money remaining at annuitant’s death
Which is best depends upon WHAT YOU’RE TRYING TO ACCOMPLISH. IT IS ESSENTIAL THAT WE DISTINGUISH BETWEEN A JOINT OWNERSHIP
DESIGNATION AND NAMING JOINT ANNUITANTS!
MENTION THAT THIS IS DISCUSSED IN “THE ANNUITY ADVISOR”
Tax consequences: J&S annuity surviving annuitant has same exclusion ratio as first annuitant, except that if survivor’s annuity
Value created ESTATE TAX liability for that portion of estate tax attributable to that survivor annuitant’s income stream

13. How is the owner of an annuity taxed if he or she sells the annuity contract? (Q381)
Ordinary income on gain.Any loss is ordinary loss. Rules not clear if annuity was sold for more than surrender value, but when would that happen?

14. What are the tax consequences when an un-matured annuity contract is transferred as a gift? (Q387)
Tax treatment depends upon date of issue of contract:
Issued AFTER 4/22/87 – all gain taxable to TRANSFEROR in year of gift. Gain taxed to transferor increases transferee’s basis.
Issued BEFORE 4/23/87 – no tax in year of gift
when contract surrendered, all gain from issue to date of gift taxed to TRANSFEROR
any excess taxed to TRANSFEREE.

15. non-annuity asset in that account,
If an annuity is held in an IRA or qualified plan, do special rules apply (that would not apply to a
non-annuity asset in that account,
Treas. Reg. §1.401(a)(9)-6)?
Yes, there are a FEW. But, GENERALLY SPEAKING, a DEFERRED annuity held within an IRA is subject to the same rules as any other IRA asset
If the annuity has been ANNUITIZED, the income payments will qualify under RMD rules, even if the annuity payment eventually is less than the amount that would be required under the Uniform Table. (Treas.Reg. §1.401(a)(9)-6, A-1. And that income may NOT be applied to satisfy the RMD of any holding other than THAT ANNUITY….BUT…
It APPEARS that this treatment is correct for years beginning in the year AFTER the contract was annuitized (or, in the case of an immediate annuity, the contract was purchased),
THIS IS NEW MATERIAL, NOT IN EITHER TAX FACTS OR “THE ANNUITY ADVISOR” 3RD ED. but, for the year of purchase, the 12/31/prior year balance includes the amount used to fund the annuity. Thus, the annuity payout can be used toward satisfaction of ALL of the traditional IRA accounts.
If a non-annuitized deferred annuity is held in an IRA and has additional benefits (including guaranteed living or death benefits), the actuarial value of those benefits must be added to the contract value for RMD purposes.
The value of any deferred annuity must, for Roth conversion purposes, include the actuarial value of any guaranteed living or death benefits, subject to a “de minimus” rule.(Treas.Reg (a)(9)-6, A-12, Treas.Reg A-4, A-14). THIS GETS TRICKY, AS THE DE MINIMIS RULE HAS AN EXCEPTION ONLY FOR BENEFITS THAT ARE REDUCED BY WITHDRAWALS ON A PRO-RATA BASIS. SOME CONTRACTS HAVE DOLLAR-FOR-DOLLAR REDUCTION PROVISIONS.

16. What are the tax consequences to the owner of an annuity who assigns the right to receive annuity payments to another, but retains ownership of the contract? (Q386)
The tax liability remains with the owner.

17. Who is considered to be the owner of an annuity held by a trust?
Are there special tax rules that apply when an annuity is owned by a trust for the benefit of a natural person?
Why would the natural person who is benefiting from the annuity want to create a trust to hold the contract? (Q354)
THERE IS A WHOLE CHAPTER ON ANNUITIES AND TRUSTS IN “THE ANNUITY ADVISOR”

18. What if the beneficiary of an annuity is a trust
What if the beneficiary of an annuity is a trust? How are payments made after the owner’s death made to the trust? (Q397)

19. How can deferred annuities be used in retirement income planning?
Are there any tax advantages to using a deferred annuity to guarantee income during retirement?
What should clients be aware of when considering this strategy?
THERE IS A WHOLE CHAPTER (CHAPTER 12) IN “THE ANNUITY ADVISOR” ON “THE ANNUITY AS A PLANNING TOOL”
Item 1 – deferred annuity is both an accumulation and a distribution instrument. WHAT ARE YOU TRYING TO ACCOMPLISH?
Item 2 – Yes, tax deferral (if contract is owned by a human) and “exclusion ratio” treatment
Item 3 – Do you WANT tax deferral? (variable vs. fixed annuity)

20. There are obviously tax benefits to using annuities in planning, but what are the risks that should be explained to clients considering an annuity strategy?
What advice would you offer your clients who are in the planning phase?
IN “THE ANNUITY ADVISOR”, THERE ARE CHAPTERS ON “ARGUMENTS FOR ANNUITIES”, “ARGUMENTS AGAINST ANNUITIES”, AND A NEWLY REVISED CHAPTER ON SUITABILITY AND THE CHANGING STANDARD OF CARE FOR ADVISORS.
[Yes, there are a few. They're my opinion, of course. (1) Don't let owner and annuitant be different parties unless you know the consequences and the benefits are worth those consequences. (2) Don't title a deferred annuity in Joint name unless you know the consequences and the benefits are worth those consequences. (3) Don't have a deferred annuity owned by or even payable to a trust unless you know the consequences and the benefits are worth those consequences. (4) Be sure that you explain to your client both the tax advantages of a deferred annuity and its tax disadvantages. (5) Make VERY, VERY sure that your client understands both when surrender charges will be imposed and how much those charges will be and when any index-linked interest (in index annuities) and "bonus" interest will be forfeited. This isn't tax related, so it's not a "tax trap", but failure to get, and document, understanding on those issues can prove very hazardous to a financial advisor.  I see those issues all the time in my Expert Witness work.]

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By John L. Olsen, CLU, ChFC, AEP, and Michael E. Kitces, MSFS, MTAX, CFP®, CLU
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