Back to Types of Annuities and Basic Tax Rules

In General

  • 495. What is an “annuity”?

    • Strictly speaking, the term “annuity” refers to a series of payments over time in which the principal (or purchase price) and interest are amortized over the payout period, so that no value remains at the end of the annuity period; it is a stream of income.However, most people who use the term “annuity” are referring to an annuity contract, under which that stream of income is guaranteed.

      There are several types of annuity contracts: (1) commercial annuities, which are contracts between a purchaser and an insurance company, (2) charitable gift annuities (see Q 607), and (3) private annuities (see Q 603). With the exception of Q 603 to Q 609, all of the discussion in this book will deal with commercial annuities.

      There are many types of commercial annuities and they are very different because they are designed to do very different jobs. For this reason, any statement that begins “Annuities are….” is probably misleading or outright false, precisely because the term covers so many different types of contract.

      The chart below shows the various types, in terms of when annuity payments begin.1

      Fig 1

      The following chart shows these types in terms of how the contract value is invested.

      Fig 2

      1 .Chart from “John Olsen’s Guide to Annuities for the Consumer” (John L. Olsen, 2015), by permission.

  • 496. What is a fixed annuity?

    • A “fixed annuity” is an annuity contract in which the value is reckoned in fixed units (in the U.S., U.S. dollars). By contrast, the value of a “variable” annuity is determined by the dollar value of its accumulation or annuity units, the value of which can and will vary over time.

      There are three classes of fixed annuities: (1) fixed immediate annuities, (2) fixed deferred annuities, and (3) fixed deferred income (“longevity”) annuities.

      A fixed immediate annuity is one that pays a defined amount of income each period (which may be level or increasing in accordance with a “cost of living” provision), commencing no later than one year after purchase, and persisting for a defined period (which may be the lifetime(s) of the annuitant(s)).

      A fixed deferred annuity is one providing for the payment of an annuity income at some later time (perhaps many years after purchase); during the accumulation period (from purchase to the annuity starting date (ASD), the contract will earn interest.

      There are two kinds of fixed deferred annuities: (1) the fixed declared rate deferred annuity, and (2) the fixed index annuity.

      The fixed declared rate deferred annuity will credit a rate of interest each year during the accumulation period. The interest rate is declared at the beginning of each period (usually, one year) and may change, though not below the guaranteed minimum interest rate.

      The fixed index annuity is identical to the declared rate annuity except that interest is credited retroactively at the end of each period (of one or more years) and will vary according to the increase in the value of one or more specified external market indices (often, the S&P500®). Like the declared rate contract, a minimum interest rate is guaranteed, provided that the contract is held for the entire surrender charge period.

      The third basic class of fixed annuities is the fixed deferred income, or “longevity” annuity. This is a contract guaranteeing a certain amount of income for a specified period (or lifetime(s)) to commence at some specified later age, usually an advanced age. During the accumulation period, there is no interest crediting and the contract may terminate without value if the annuitant dies prior to the ASD, although some contracts provide for a pre-ASD death benefit.

  • 497. What is a fixed immediate annuity?

    • A fixed immediate annuity is an immediate annuity (a contract in which regular annuity payments must commence no later than one year after purchase) in which the payments will remain level or increase only in accordance with a “cost of living” rider, if elected. The payments will persist for the entire annuity payout period, which may be a term of years, the lifetime(s) of one or two annuitants, or the latter, with a “refund provision” that will take effect if the annuitant(s) die prior to the refund guarantee period.

      Some older fixed immediate annuities are not “commutable” (i.e., they cannot be modified after annuity payments begin). Others provide for commutation, including the right of the owner to take a cash settlement in lieu of future annuity payments.

  • 498. What is a fixed deferred annuity?

    • A fixed deferred annuity is a deferred annuity (i.e., one in which regular annuity payments may be deferred), the value of which is represented in fixed units (U.S. Dollars) rather than variable units (as is the case in a variable annuity). There are two basic types of fixed deferred annuities:

      “Declared rate” fixed deferred annuities, in which the interest rate to be credited is declared prospectively by the issuing insurer at the beginning of each crediting period (which may be annually or every few years) and is credited at the end of each crediting period. (See Q 499.)

      “Indexed” fixed deferred annuities (commonly called “index annuities”), in which interest to be credited is declared retrospectively at the end of each crediting period. The interest rate to be credited is linked to the change in value of an external index (which may be the S&P500® or some other commonly used index). Most contracts permit the owner to select more than one index to be used in such crediting. (See Q 500.)

      Both contracts offer a guarantee of principal and a minimum interest crediting guarantee, provided that the contract is held to the end of the surrender charge period. The current interest declared in a guaranteed rate deferred annuity may never be lower than the contractually guaranteed minimum rate.

      In all deferred annuities, there are two periods: (1) The accumulation period, during which interest is credited to the cash value of the contract, and during which partial withdrawals or surrenders may be made, and (2) the payout, or annuity period, during which regular annuity payments are made to the owner, pursuant to the annuity payout election made.

      Typically, annuitization may be elected at any time beyond the first year or few years, and must be elected by the maturity date (at which point the contract must be annuitized).

  • 499. What is a fixed declared rate deferred annuity?

    • A fixed declared rate deferred annuity is a deferred annuity (i.e. one in which annuity payments may be deferred), represented in terms of fixed units (U.S. dollars), in which interest is declared prospectively, at the beginning of each crediting period (which may be one year or every N years). It has all the characteristics of other fixed deferred annuities (see Q 498), including a guarantee of principal (provided that the contract is held to the end of the surrender charge period) and a guaranteed minimum rate of interest.

  • 500. What is a fixed index annuity (“index annuity”)?

    • A fixed index annuity is a fixed deferred annuity in which interest crediting is done retroactively, at the end of the crediting period (which may be one year or more) and where the crediting rate is linked to the changes in the value of an external index such as the S&P500®. Most contracts offer multiple indices and the contract owner may select one or more of them.

      There are no immediate index annuities because interest crediting is done retroactively and the insurer cannot link interest assumed in the annuity benefit guaranteed at the time of issue to future changes in the index or indices.

      While some index annuities have been registered as securities by the issuing insurer, most contracts are not, and are not considered securities by the SEC. That said, some state securities departments assert jurisdiction over their sales. The sale of fixed index annuities was set to become subject to the “best interest contract” (BIC) prohibited transaction exception (PTE) of the fiduciary duty rule published by the Department of Labor (DOL) in 2016, whereas sales of declared rate fixed deferred annuities were to be allowed in accordance with the less-onerous PTE 84-24. However, the Fifth Circuit vacated the DOL fiduciary rule in March 2018, and DOL officially removed the best interest contract exemption in 2020 (see Q 3983 for a discussion of the proposed PTE designed to replace the 2016 rule).

      Like all fixed deferred annuities, an index annuity guarantees a minimum interest rate provided that the contract owner holds the contract for the entire surrender charge period, though the guaranteed rate for index annuities is typically lower than that of declared rate contracts. Both types may include a market value adjustment (MVA) (see Q 530) and typically impose a schedule of surrender charges (which may vary widely in size and duration).

      There are many different methods of interest crediting. All of them begin with the calculation of the percentage change in the value of the indices chosen over the crediting period, usually, but not always, excluding dividends on the stocks in those indices. That percentage change is then modified by the application of one or more crediting factors, or “moving parts”, in the contract, and the result is the interest percentage to be credited to the annuity contract. The most typical “moving parts” are as follows:

      Participation Rate: The participation rate is the percentage of the increase in the index that will be used to calculate index-linked interest. For example, if the index value rises by 9 percent over the crediting period (which may be one year or more) and the participation rate is 70 percent, the index-linked interest rate to be credited at the end of the period is 6.3 percent (9% x 70% = 6.3%) if there are no other modifying factors. The participation rate may be guaranteed for the life of the contract or for only one crediting period (and may be changed for the next period). A minimum participation rate is usually guaranteed.

      Spread/Margin/Administrative Fee: Some indexed annuities use a spread, margin or administrative fee in addition to, or instead of, a participation rate. This percentage will be subtracted from any gain in the index linked to the annuity. For example, if the index gained 10 percent and the spread/margin/fee is 3.5 percent, then the gain in the annuity would be only 6.5 percent.

      Interest Rate Caps. Some indexed annuities may put a cap or upper limit on total return. This cap rate is generally stated as a percentage. This is the maximum rate of interest the annuity will earn. For example, if the index linked to the annuity gained 10 percent and the cap rate was 8 percent, then the gain in the annuity would be 8 percent. (Note that indexed annuities that have caps may have a higher a participation rate.) Some contracts use an index rate cap, which is the maximum amount of index change that will be recognized before application of other modifications, rather than a cap on the amount of interest to be credited (“interest rate cap”). As with the participation rate, the interest rate cap may be guaranteed for the life of the contract or for only one crediting period. Typically, a minimum cap value is guaranteed.

      Contract Designs

      There are several index annuity designs. The simplest is the “Annual Point to Point”, which measures the percentage change in the index each year and credits that change (after modifications) as interest at the end of each period.

      “Term End Point” is a design that measures the index change at the end of a multi-year term and credits that change, after modifications, as interest at the end of the term.

      “Averaging” is used in some designs, so that the average percentage change in the index, rather than the point-to-point change, is used. In “monthly averaging”, most contracts place a cap on the positive monthly changes but not on any negative changes (monthly losses).

      There are many index annuity designs and some are extremely complicated. For example, a newer design is to use an index that controls for volatility of changes in the raw index.

      No Market Losses

      Nearly all index annuities provide that any negative changes in the index over the crediting period will be credited as a 0 percent gain. Thus, the buyer of an index annuity is not subject to any market losses. However, it is not true to say that one cannot lose money in an index annuity, as surrender charges and/or market value adjustments may result in a surrender value lower than the original purchase amount, but only if the contract is surrendered during the surrender charge period.

  • 501. What is a variable annuity?

    • There are two types of variable annuities: (1) variable immediate annuities and (2) variable deferred annuities.

      For both types, the value of the contract (the cash value of the deferred contract or the size of the income payment of the immediate contract) varies with the performance of the “separate accounts” chosen (see Q 510).

      Unlike fixed deferred annuities, variable deferred annuities do not guarantee either a minimum rate of interest or safety of principal. Indeed, the concept of “interest” can be misleading when applied to a variable deferred annuity, as the value of the contract does not vary by the addition of interest, but in the fluctuating value of the “accumulation units” purchased in the “separate accounts”. (For monies allocated to the “fixed account” of a variable deferred annuity, principal is generally guaranteed and a set rate of interest is credited each year).

      Planning Point: The SEC has recently proposed changing the disclosure rules that apply to carriers that sell variable annuity products in order to allow them to use a summary prospectus in order to more clearly explain the features and risks of these complicated variable annuity products.

      Variable immediate annuities differ from fixed immediate annuities in that the size of the payments is not guaranteed but varies according to investment performance of the “separate accounts” (see Q 510).

  • 502. What is a “no load” variable annuity? What should individuals keep in mind when considering these products?

    • No load variable annuities are a type of annuity that have been developed to alleviate some of the concern over the mounting fees associated with the general product class of variable annuities, and are generally able to charge lower fixed fees because the advisor who sells the product is not paid a commission with respect to these sales. Further, the products can allow the taxpayer to manage the investments himself (or determine who will manage the investments) to reduce the cost of investment management fees.

      No load products also typically do not have surrender charges—meaning that the investor can maintain a degree of liquidity that might not otherwise be available with a traditional product.

      Because of the fact that the no load variable annuity does not generate a commission for an advisor, taxpayers may be tempted to buy them directly, which means that the individual will be responsible for determining whether the annuity is a good fit. Fee-based advisors may also be able to facilitate a purchase, but the assistance available in understanding these products to begin with may not be as robust as is the case with a traditional product. This means that a no load product may not be the best choice for an unsophisticated individual without proper guidance.

      Add-on riders (which are sometimes the primary attraction of the annuity product) will still generate additional costs when added to a no load variable annuity. Some products do not even offer some of the more common income guarantee features that individuals have come to associate with annuities. Further, the funds contained in the annuity’s sub-accounts can continue to add fees to the product itself—individuals should not confuse “low fee” for “no fee” products.

  • 503. What is an immediate variable annuity?

    • A variable immediate annuity is an immediate annuity in which the amount of each year’s annuity payment varies with the investment performance of the “separate accounts” chosen by the contract owner (see Q 510).

      With regard to the taxation of annuity payments made under a variable immediate annuity (or a deferred contract that has been annuitized under a “variable payout option”), it would not be feasible, or equitable from a revenue standpoint, to apply the regular annuity rules in taxing such payments. If investment experience were very favorable, for example, the application of a constant exclusion ratio would result in a correspondingly increased tax-free portion.

      Treasury regulations, therefore, provide special rules for taxing variable annuities. However, for taxable years beginning after December 31, 1983, a variable annuity contract will not be treated as an annuity and taxed under these rules unless the underlying investments of the segregated asset account are adequately diversified.1 (See Q 550.)

      In general, these rules provide that the amount which can be excluded from gross income in a taxable year is the portion of the investment in the contract which is allocable to that year. This is determined by dividing the investment in the contract by a multiple taken from the annuity tables which represents the anticipated number of years over which the annuity will be payable.2 All amounts received in excess of this yearly exclusion are fully taxable. The amount so determined may be excluded from gross income each year for as long as the payments are received if the annuity starting date was before January 1, 1987.

      In the case of an annuity contract with a starting date after 1986, the amount determined may be excluded from gross income only until the investment in the contract is recovered.3

      1 .IRC Sec. 817(h).

      2 .Treas. Reg. §1.72-2(b)(3).

      3 .IRC Sec. 72(b)(2).

  • 504. What is a variable deferred annuity?

    • A variable deferred annuity is a kind of deferred annuity in which the contract value can, and usually will, vary daily to reflect the performance of the “separate accounts” (see Q 510) chosen. As with all deferred annuities, there are two periods in the contract.

      The “accumulation period” lasts from contract issue until the annuity starting date (ASD) (see Q 536), during which the “accumulation units” of the separate accounts chosen will vary in value (and the contract value, which is the sum of those units), as well. Interest is not credited to a variable deferred annuity. Any contract “gain” is the result of increases in the value of the accumulation units chosen.

      The “annuity” or “payout” period lasts from the ASD until the end of the annuity payout period chosen. During this period, the amount of each year’s annuity payments will vary to reflect investment performance unless a “fixed” annuity payout method has been chosen (in which case, the payouts will act like, and be taxed like, payments under a fixed contract.

  • 505. What is a deferred income (“longevity”) annuity?

    • A deferred income annuity, which is sometimes referred to as a “longevity annuity” (DIA) or an advanced life deferred annuity (ALDA) – is an annuity contract that (generally) provides no cash value or death benefits during a deferral period, and begins to make annuitized payments for life at the end of that period, if the annuity owner is still alive. For instance, the contract for a sixty-year-old might provide that payments will not begin until age eighty-five, but upon reaching that age, payments will be made for life; due to the long deferral period and the accumulation of significant mortality credits, the payments that ultimately begin may be very large relative to the original payment amount. Some deferred income annuities offer a pre-annuity starting date death benefit equal to the premium paid or premium paid plus a stipulated rate of interest. These contracts provide significantly lower guaranteed annuity payments than those with no such benefit.

      The IRS has issued a private letter ruling explaining the tax treatment of a so-called longevity annuity.1 According to the IRS, a longevity annuity qualifies for favorable treatment, which means payments are taxed under the exclusion ratio (“amounts received as an annuity”) rules when they begin.

      This treatment applies as long as, on the deferral period end date, the contract’s contingent account value becomes the cash value and is accessible by the owner through:

      (1) the right to receive annuity payments at guaranteed rates,

      (2) the right to surrender the contract for its cash value,

      (3) the right to take partial withdrawals of the cash value, and

      (4) a death benefit.

      The IRS concluded that a longevity annuity is an annuity contract for purposes of IRC Section 72 because the contract is in accordance with the customary practice of life insurance companies and the contract does not make periodic payments of interest.

      In support of its first conclusion, the IRS noted that insurance companies historically have issued deferred annuity contracts that, like longevity annuities, did not have any cash value during the deferral stage and did not provide any death benefit or refund feature should the annuitant die during this time. Thus, in the IRS’ opinion, survival of the annuitant through the deferral period is not an inappropriate contingency for the vesting of cash value and the application of annuity treatment to the proposed contract.

      In reaching the second conclusion, the IRS took note of the fact that the longevity annuity (1) provides for periodic payments designed to liquidate a fund, (2) contains permanent annuity purchase rate guarantees that allow the contract owner to have the contingent account value applied to provide a stream of annuity payments for life or a fixed term at any time after the deferral period, and (3) provides for payments determined under guaranteed rates.

      1 .Let. Rul. 200939018.

  • 506. What is an indexed variable annuity?

    • Although known by several different names and subject to a broad range of potential product features, an indexed variable annuity is essentially an annuity product where investment returns are tied to the performance of one or more stock indices (e.g., the S&P 500 or the Dow Jones). Unlike straight equity investing, however, the product itself offers a cushion against investment losses in exchange for a cap on the potential for investment gains.

      Unlike fixed indexed annuities, in an indexed variable annuity, principal is not necessarily guaranteed. The carrier may offer 10, 15, or 20 percent (or more) buffers against investment losses, meaning that if the underlying investments generate a loss, the insurance carrier absorbs a set percentage of that loss before the taxpayer experiences any loss. As such, if the chosen index declines, for example, by 10 percent and the taxpayer has chosen a 15 percent buffer, the taxpayer’s account value will decline only by the 5 percent loss that exceeds the contract’s downside protection.

      However, as a trade-off for the downside protection afforded by these contracts, participation in the linked index’s gains will be subject to a cap for a fixed term of years. Despite this, the term of years can be as short as a single year for some contracts, allowing the taxpayer a degree of flexibility that he or she might not otherwise find available in a fixed indexed annuity product. Further, some contracts provide for an upside cap that fluctuates annually—or, in some cases, as frequently as weekly or monthly.

      Some insurance carriers even offer products that cover 100 percent of the downside risk of the investment, but these carriers also set the upside caps on these contracts at a lower percentage (in some cases, as low as 1.5 percent) that resets frequently (for example, every two weeks).

      Despite their lack of guaranteed principal, indexed variable annuities offer many of the benefits that traditionally accompany an annuity product, including the valuable elements of tax deferral and death benefits for account beneficiaries.

  • 507. What is a buffer or registered indexed linked annuity?

    • Registered indexed-linked annuities are a type of annuity that does not protect (or claim to protect) completely against the risk of investment losses. Registered indexed-linked annuities focus on accumulation, rather than income protection. Most of these products only offer a degree of downside protection (they provide a “buffer” against market losses). For example, when a registered indexed-linked annuity offers 10 percent downside protection against market losses, the insurance company that sold the product will absorb the first 10 percent of losses. The investor then experiences the remainder of the loss (the investor is able to choose the degree of risk he or she is willing to take on, based on the product and the carrier).

      On the other hand, some forms of registered indexed-linked annuities work in the opposite way, so that the investor will take on a certain degree of risk (i.e., using the example above, the investor is responsible for the first 10 percent of market losses), after which the insurance company steps in to assume any additional loss.

      Although these products are riskier than traditional fixed or indexed annuity products (that often provide protection against any loss of principal), they can offer higher “caps” than most indexed annuities. A cap essentially serves to cap the buyer’s credited interest at the cap amount (for example, if the market gained 10 percent and the cap is 6 percent, 6 percent will be credited, but if the gain was 1 percent, the investor would receive the 1 percent credit because it is less than the cap amount). Registered indexed-linked annuities can offer caps of around 8 to 9 percent.

      Because of these higher caps, registered indexed linked (or buffer) annuities can allow an investor to more fully participate in market gains, which is appealing to many who feel that annuities create opportunity losses when the markets are strong, as they arguably still are today. See Q 510 for a discussion of some of the risk that must be considered when an investor is considering purchasing a registered indexed linked annuity.

  • 508. What should an individual consider when deciding whether to invest in a buffer or registered indexed linked annuity?

    • Individuals who wish to procure the more traditional income protection offered by annuities during retirement should think twice about the risks involved with registered indexed-linked annuities. Individuals who are already in retirement may be drawn to the potential for increased gains, but be unable to comfortably assume the greater risk of lost principal that is associated with registered indexed-linked annuities. This makes it important for these potential investors to understand the difference between the downside protection offered by registered indexed-linked annuities, and the “floor” provided by many other types of annuity products.

      The floor offers a limit below which the product’s earnings is guaranteed not to fall, but registered indexed-linked annuities only limit the investor’s risk of loss by a certain percentage—which can impact the investor’s principal investment, as well as earnings on the investment.

      Another risk associated with registered indexed-linked annuities lies in the complexity of the products. Many taxpayers may not fully understand the risk that they are assuming, which can lead to unpleasant future surprises.

  • 509. What is a fee-based annuity? Why have fee-based annuities become popular and what should individuals understand before deciding to purchase a fee-based annuity?

    • Generally, a fee-based variable annuity charges an ongoing asset-based fee instead of providing the advisor with a traditional commission. These products became more popular because these fees are typically “level,” so that firms that sell them were not required to comply with the onerous requirements of the DOL’s best interests contract exemption. Now that the DOL fiduciary rule has been vacated, many firms may remain attracted to fee-based annuities because of the uncertainties surrounding the five-part test that will now apply to determine fiduciary status, as well as potential new fiduciary standards that may become applicable.

      Planning Point: The IRS has released a private letter ruling concluding that when an advisor takes a fee directly from a non-qualified annuity product, that withdrawal is not treated as a taxable transaction.  The annuity in question involved fee-based annuities, where the advisor was not entitled to receive a commission for the sale in addition to the fee.  While this ruling is widely viewed as positive for fee-based advisors and clients who are interested in these products, clients should be advised that although private letter rulings do give some indication of the IRS’ view on the issue at hand, these rulings are technically only applicable to the taxpayer that requested the ruling–meaning that the client cannot rely upon the ruling unless the relevant issuer has obtained a private letter ruling.

      Historically, advisors have been compensated for the sale of variable annuity products on a commission basis, which is believed to motivate advisors to recommend products because of their high commission value, rather than because they are in the client’s best interests. This structure generates concern both that the advisor’s compensation may not be reasonable and that fiduciary liability may attach even in the post-DOL fiduciary rule environment.

      However, because fee-based products charge an ongoing fee, they can potentially be more expensive for clients in the long run. Some carriers have sought to make their fee-based annuity products more attractive by providing living and death benefit riders that can serve to increase the value of the contract to the client (and can, in some circumstances, justify a higher overall price for the client who values these features). However, for some clients, a commission-based product which guarantees living benefits may be cheaper because the client will hold the product for many years.

      Further, some fee-based products may provide for very short surrender charge periods, an option that adds value for the client because it limits the period of time during which he or she is locked into the product. For clients who anticipate the possibility of accessing the annuity investment early, the higher price of the fee-based annuity may be justifiable.

      The client should also look to the costs of the underlying sub-accounts of a variable annuity product, which can influence the value of the product. If the product is an indexed annuity, the various caps, spreads and interest rate guarantees should be examined to determine the value offered by the product.

  • 510. What are the “separate accounts” in a variable annuity?

    • The “separate accounts” in a variable immediate or deferred annuity are investment accounts, similar in some respects to mutual funds, with specified investment objectives. The contract owner purchases these accounts in “accumulation units” (for deferred variable annuity contracts) or “annuity units” (for immediate variable annuities). The cash value of the deferred annuity and the amount of each annuity payment in the immediate annuity will vary according to the performance of these units, which are re-priced daily.

      There is, in both immediate and variable annuities, an annual expense charge of each separate account which impacts the cash value of the deferred contracts and the amount of annuity payments in immediate contracts. The amount of this charge can usually change over time, and, in some contracts, may be waived in some years.

      Variable deferred annuity contracts also offer “fixed” accounts, which act like fixed deferred annuities in having a guarantee of principal and a fixed rate of interest that is usually declared each year. There is no annual expense charge for this “fixed” account.

  • 511. What are annuity payout arrangements?

    • An annuity payout arrangement is a prescribed method in which regular annuity payments will be received under an immediate annuity or a deferred annuity that is being “annuitized”. The charts below shows the various arrangements. Not all arrangements may be available in a particular annuity contract.

  • 512. What general rules govern the income taxation of payments received under annuity contracts?

    • The rules in IRC Section 72 govern the income taxation of all amounts received under nonqualified annuity contracts. IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns. Qualified annuity contracts are governed by the tax rules of the retirement account in which they are held.

      All“amounts received” under an annuity contract are either “amounts received as an annuity” or “amounts not received as an annuity.”

      “Amounts received as an annuity” (annuity payments) are taxed under the annuity rules in IRC Section 72. These rules determine what portion of each payment is excludable from gross income as a return of the purchaser’s investment and what portion is taxed as interest earned on the investment. They apply to life income and other types of installment payments received under both immediate annuity contracts, and deferred annuity contracts that have been annuitized (Q 527 to Q 546).1

      Payments consisting of interest only are not annuity payments and thus are not taxed as “amounts received as an annuity.” Periodic payments on a principal amount that will be returned intact on demand are interest payments.2 Such payments, and all amounts taxable under IRC Section 72 other than regular annuity payments, are classed as “amounts not received as an annuity.” These include amounts actually received as policy dividends, lump sum cash settlements of cash surrender values, cash withdrawals and amounts received on partial surrender, death benefits under annuity contracts, a guaranteed refund under a refund life annuity settlement,3 and policy loans, as well as amounts received by imputation (annuity cash value pledged as collateral for a loan). “Amounts not received as an annuity” are taxable under general rules discussed in Q 515 and Q 523. The taxation of distributions from life insurance policies is discussed in Q 10 and Q 13.

      Except in the case of certain annuity contracts held by non-natural persons (Q ), income credited on a deferred annuity contract is not currently includable in a taxpayer’s income. There is no specific IRC section granting this “tax deferral.” Instead, it is granted by implication. The increase in cash value of an annuity contract, other than by application of dividends, is neither an “amount received as an annuity” nor an “amount not received as an annuity.” As a result, an increase in cash value is not a distribution and is not includable in the taxpayer’s income, except where the IRC specifically provides otherwise (Q 513).

      IRC Section 72 places a penalty on “premature distributions” (Q 523).

      Contracts issued after January 18, 1985 have post-death distribution requirements (Q 593). These post-death distribution requirements also apply to contributions made after January 18, 1985, to contracts that were issued before that date. Contracts issued before January 18, 1985, with contributions that were made before that date are not subject to post-death distribution requirements.

      The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of life insurance death proceeds. However, the rules for taxing such payments are similar to the IRC Section 72 annuity rules (Q 63 to Q 79). On the other hand, as noted earlier, death proceeds under an annuity contract (i.e., from some form of guaranteed death benefit) are taxed as amounts not received as an annuity (Q 515, Q 523).

      Employee annuities, under both qualified and nonqualified plans, and periodic payments from qualified pension and profit sharing trusts are taxable under IRC Section 72, but because a number of special rules apply to these payments, they are treated separately (Q 3532 to Q 3539, Q 3943 to Q 3977, Q 4087).

      Annuity with long-term care rider. Under the Pension Protection Act of 2006, qualified long term care insurance can be provided as a rider to an annuity contract, beginning after December 31, 2009.

      1 .IRC Sec. 72(a); Treas. Reg. §1.72-1.

      2 .Rev. Rul. 75-255, 1975-2 CB 22.

      3 .Treas. Reg. §1.72-11.

  • 513. How are annuity contracts held by corporations and other non-natural persons taxed?

    • Except as noted below, to the extent that contributions are made after February 28, 1986, to a deferred annuity contract held by a corporation or another entity that is not a natural person, the contract is not treated for tax purposes as an annuity contract.

      When an annuity contract is no longer treated as an annuity for tax purposes, income on the contract is treated as ordinary income received or accrued by the owner during the taxable year.1 “Income on the contract” is the excess of (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (the amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement.2

      This rule does not apply to any annuity contract that is:

      (1) acquired by the estate of a decedent by reason of the death of the decedent;

      (2) held under a qualified pension, profit sharing, or stock bonus plan, as an IRC Section 403(b) tax sheltered annuity, or under an individual retirement plan;

      (3) purchased by an employer upon the termination of a qualified pension, profit sharing, or stock bonus plan or tax sheltered annuity program and held by the employer until all amounts under the contract are distributed to the employee for whom the contract was purchased or to the employee’s beneficiary;

      (4) an immediate annuity (i.e., an annuity that is purchased with a single premium or annuity consideration, the annuity starting date of which is no later than one year from the date of purchase, and that provides for a series of substantially equal periodic payments to be made no less frequently than annually during the annuity period); or

      (5) a qualified funding asset (as defined in IRC Section 130(d) but without regard to whether there is a qualified assignment).3 A qualified funding asset is any annuity contract issued by a licensed insurance company that is purchased and held to fund periodic payments for damages, by suit or agreement, on account of personal physical injury or sickness.4

      These requirements apply “to contributions to annuity contracts after February 28, 1986.”5 It is clear that if all contributions to the contract are made after February 28, 1986, the requirements apply to the contract. It seems clear enough that if no contributions are made after February 28, 1986, to an annuity contract, such contract held by a non-natural person is treated for tax purposes as an annuity contract and is taxed under the annuity rules (Q 512). If contributions to a contract held by a non-natural person have been made both before March 1, 1986, and after February 28, 1986, however, it is not clear whether the income on the contract is allocated to different portions of the contract and whether the portion of the contract allocable to contributions before March 1, 1986, may continue to be treated as an annuity contract for income tax purposes. The IRC makes no specific provision for separate treatment of contributions to the same contract made before March 1, 1986, and those made after February 28, 1986.

      For annuity contracts held by a non-natural person as agent for a natural person, see Q 514.

      1 .IRC Sec. 72(u).

      2 .IRC Sec. 72(u)(2).

      3 .IRC Sec. 72(u)(3).

      4 .IRC Sec. 130.

      5 .TRA ’86 Sec. 1135(b).

  • 514. If an annuity is held by a trust or other entity as agent for a natural person, does the general rule that annuities held by non-natural persons are not taxed as annuities apply?

    • An annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person.1 If a non-natural person is the nominal owner of an annuity contract but the beneficial owner is a natural person, the annuity contract will be treated as though held by a natural person.2 Also, an annuity owned by a grantor trust will be considered to be owned by the grantor of the trust.

      In a letter ruling, the IRS decided that a trust was considered to hold an annuity contract as an agent for a natural person where the trust owned an annuity contract which was to be distributed, prior to its annuity starting date, to the trust’s beneficiary, a natural person.3

      In another ruling, the IRS considered an irrevocable trust whose trustee purchased three single premium deferred annuities, naming the trust as owner and beneficiary of the contracts and a different trust beneficiary as the annuitant of each contract. The terms of the trust provided that the trustee would terminate the trust and distribute an annuity to each trust beneficiary after a certain period of time. The IRS held that the non-natural person rule was not applicable.4

      The IRS concluded that the non-natural person rule does not apply to a trust that had invested trust assets in a single premium deferred variable annuity where the same individual was the sole annuitant under the contract and the sole life beneficiary of the trust.5

      Where a trustee’s duties were limited to purchasing an annuity as directed by an individual and holding legal title to the annuity for that individual’s sole benefit and the trustee was not able to exercise any rights under the annuity contract unless directed to do so by the individual, the IRS concluded that the trustee was acting as an agent for a natural person.6

      Further, where the trustee of an irrevocable trust purchased an annuity and had the power to select an annuity settlement option or terminate the annuity contract, the annuity was still considered to be owned by a natural person.7

      A charitable remainder unitrust, however, was not considered to hold an annuity contract as an agent for a natural person and, thus, was required to include income on any annuity contracts in ordinary income each year.8

      Although it is not entirely clear that all permissible beneficiaries of a trust named as owner of a deferred annuity must be natural persons, it is significant that, as of June 2010, all private letter rulings addressing whether a trust named as owner of a deferred annuity was acting as “the agent of a natural person” have specified that all beneficiaries were, in fact, natural persons.9

      If all beneficiaries of a trust owning a deferred annuity must be natural persons, must the term “beneficiary” be taken literally? In the case of a “special needs” trust (such as an OBRA “D(4)(A)” trust), it is not clear whether the position of creditor occupied by the state Medicaid agency (to the extent of any Medicaid payments made to the trust beneficiary) will constitute the interest of a “beneficiary,” where the state Medicare statute does not specify that the state’s interest is that of a “beneficiary.”

      1 .IRC Sec. 72(u)(1).

      2 .H.R. Conf. Rep. No. 99-841 (TRA ’86) reprinted in 1986-3 CB Vol. 4 401.

      3 .Let. Rul. 9204014.

      4 .Let. Rul. 199905015.

      5 .Let. Rul. 9752035.

      6 .Let. Rul. 9639057.

      7 .Let. Rul. 199933033.

      8 .Let. Rul. 9009047.

      9 .Let Ruls. 20049011, 20049013, 20049014, 20049015, 20049016, 200018046.