IRD Rules for Annuities

[Snaggletooth]

Money in tax-deferred annuities is taxable to the beneficiaries to the extent they exceed decedent's cost.

When is it taxable? Can the beneficiaries draw down the annuity over a five-year period? Is it immediately
taxable when they receive it? Can they hold off taxation by not accessing the funds?

[appelman]

I believe you have 3 options for an non-qualified annuity.

Take out the money as a lump sum.
Take the money out within 5 years, using whatever schedule of distributions you wish.
Annuitize over the beneficiary's life expectancy or a shorter period. (I think you have only 30 days to choose this option.)

[Snaggletooth]

Thanks

Thanks Appelman. It's good to have a forum such as this where knowledgeable people can share their expertise.

[New York Enrolled Agent]

I will slightly disagree.

Generally, on the death of the annuitant the gain in a lump sum payment is taxable to the beneficiary whether the beneficiary takes actual receipt or leaves the money in an interest bearing account with the insurance company. The gain is considered IRD. I don't believe there is any special 5-year rule for distributions.

§72(h) provides a way to avoid the lump sum tax - a beneficiary may elect to apply the death benefit under a life income or installment option. This election must be done within 60 days after the day the lump sum becomes payable. I understand there is some controversy about when the "lump sum becomes payable". Is it 60 days from the day of death? Or is it 60 days from when the beneficiary can submit a claim (i.e. a death certificate is available, etc.). I don't believe the IRS has given a definitive answer on this.

[Snaggletooth]

This is Scary

In other words, if the 60-day period has already expired, my client is outa luck.

The stake in the ground for defining the "clock" on the 60 days not being established,
I will use that ambiguity to the best I can.

[appelman]

I believe the reference is Sec. 72(s)(1)(B).

It is a little sketchy, but almost all secondary sources I have seen agree about the 5-year option. See, for example:

http://www.investopedia.com/ask/answers/09/inherited-annuity-distribution.asp#axzz2B255y8Y3

But NYEA is right about the deadline for annuitization being 60 days rather than 30 days.

[New York Enrolled Agent]

It is a little sketchy, but almost all secondary sources I have seen agree about the 5-year option. See, for example:

I believe (though I stand to be corrected) that §72(s) is not a definitive distribution option for beneficiaries but rather a qualification in order for an investment product to qualify as an annuity contract. If the annuitant dies before the annuity starting date the insurance company must permit the entire interest in the annuity to be distributed within 5 years of the death.

A snip from Letter Ruling 9346002:
Section 72(s) of the Code does not defer the recognition of income that otherwise is includible in gross income. Rather,
section 72(s) mandates certain terms (that is, minimum distribution rules) that must be included in a contract in order for the contract to qualify as an annuity contract for purposes of section 72.

A taxpayer may, in lieu of a lump sum, opt for a life income or installment option as per §72(h). I don't believe there is a 5 year requirement under an installment option. Reg. §1.72-2(b)

[Roland Slugg]

IRD? Did you mean MRD or RMD?

First I must admit that I'm not sure what this post is asking. The subject line refers to "IRD," but the only meaning I know of for the acronym IRD is Income in Respect of a Decedent ... an estate tax concept. Yet the rest of the post says/asks nothing about IRD. Did you mean "MRD" Snag, or, more correctly, "RMD?" The follow-on posts, including your own, make me believe the reference to "IRD" may have been unintentional. The OP also did not say, but based on the others' replies, I'm assuming the annuity in question is a non-qualified deferred annuity (NQDA), not a "qualified" one ... i.e. a retirement plan or IRA.

A non-spouse beneficiary of an NQDA generally has two options for taking distributions from the inherited account. The first is that the bene may take annual distributions based on his (the bene’s) life expectancy beginning in the year after the original owner died. If that method is not chosen, the beneficiary must take a complete distribution of the account before the end of the fifth year after the original owner’s death.

If the annuity contract contains the correct wording, and I assume they all due, then the usual annuity rules apply in determining the taxable/excludable portions of the payouts.

You may wish to refer to Code §72(s)(1), (2) and (3). Different rules apply to variable annuities. See Regs §1.72-2 and §1.72-4.

[Snaggletooth]

Income in Respect of Decedent

IRD was the intent of the original post. The client is 68 and is the recipient of a tax-deferred annuity from his father who passed this year at age 92. Client wants to know options so as to choose the minimum recognition of income for himself, and actually leave to decedent's grandchildren in the event of his own death.

I don't think I mentioned this in the original post, but client wants to take this annuity and roll it over into Roth IRA. The annuity was not associated with his father's pension plan, and my client doesn't have any earned income. I didn't think it was worth wasting time on the forum to discuss this, as I can't see how he qualified.

[Roland Slugg]

Snag, I still think you are confusing your terms. IRD refers to income reportable on someone's income tax return that was also reported on a decedent's Estate Tax Return ... F-706 ... and then getting an itemized deduction to offset a small portion of that income. You really seem to be asking about options available to someone who is the beneficiary of an annuity or the 2nd covered life by a joint life annuity.

No, it certainly can't be rolled over into a Roth IRA, although it may be possible to roll it into a traditional IRA. But why would you? I would refer this client to the insurance company that sold the annuity, or to an agent, who should be able to authoritatively answer all his questions.

[appelman]

The issue seems to be the 5-year distribution period.

NYEA thinks no. Roland and I think yes. If Sec. 72(s) isn't a good reference, I guess I don't have a primary source. But if NYEA is right, it looks as though one helluva lot of financial advisers are wrong. Fifty million Frenchmen can, indeed be wrong, but there is a certain burden of proof on the one who says so.

[Snaggletooth]

Beg to Differ

I would refer this client to the insurance company that sold the annuity, or to an agent, who should be able to authoritatively answer all his questions.

I spend a great deal of time and effort unraveling the damage done to clients by bankers, insurance agents, brokers, etc. because their financial products often overlook the tax effects. In many cases, you need look no further than the fees to find out why a product was sold.

It appears that the rules for redistribution and the rules for IRD recognition of income may be different, and this is causing part of the confusion. From the above discussion it appears some of the options for reinvestment do not necessarily relieve the beneficiary from having to recognize the totality of income in the first year...

[appelman]

Not IRD

Snag, I wish you would take Roland's advice and stop thinking in terms of IRD. This has absolutely nothing to do with IRD. Regarding the 5-year withdrawal, here is another reference.

https://www.vanguard.com/vvap/Pdf/vudc.pdf?2210035747

Regardless of what you think of financial advisers, Vanguard tends to be quite conservative, and I don't think they make many mistakes. Obviously, you won't go wrong if you make the beneficiary take a lump-sum distribution and pay all the tax now, but it probably won't be in his/her best interests to do so.

[New York Enrolled Agent]

First, Snags is absolutely correct in using IRD. The gain in the annuity payable to the beneficiary is IRD - See Letter Ruling 200041018.

Second, I repeat what I posted from Letter Ruling 9346002:
Section 72(s) of the Code does not defer the recognition of income that otherwise is includible in gross income. Rather,
section 72(s) mandates certain terms (that is, minimum distribution rules) that must be included in a contract in order for the contract to qualify as an annuity contract for purposes of section 72.

This section dictates that the insurance company must allow the distribution within a five year period if the conditions in §72(s) are met. They can't hold the money on their terms.

Now look at the Vanguard cite: The first choice is taking a lump sum, the second choice is applying §72(s) and the third choice applies §72(h). §72(h) permits the tax to be spread over a life income option or an installment option. Note in the installment option the beneficiary is able to determine the set number of years. This option doesn't require 5 or any other specific number of years.

Vanguard says:
Lump-sum distribution. You can receive a lump-sum payment equal to your share of the annuity’s market value at the
time Vanguard receives all of the required documents. If a death benefit value is greater than the market value, you can
receive the death benefit through this option. All earnings are taxable as ordinary income in the year you receive them.

Five-year deferral. Your share of the market value will be converted to a five-year deferred annuity. You can take up
to five years from the owner’s death to withdraw your share of the assets. Earnings continue to accumulate tax-deferred.

Annuitization. You can annuitize the market value or the death benefit value, whichever is greater. By annuitizing, you
convert assets into a stream of income payments. Payments can last for life or a set number of years. The decision to annuitize is irrevocable, and payments must begin within one year of the owner/annuitant’s death.

[Snaggletooth]

IRD is indeed 99% of the question

I probably did a poor job in presenting the question in the original post, but having to wrestle with IRD THIS YEAR is indeed the reason for bringing the question to the forum. My client is a beneficiary and wants to postpone reporting the annuity gain on his tax return THIS YEAR.

Much of what NYEA says is that although options exist for re-investing the funds and receiving further deferrals, none of these options relieves the taxpayer from having to recognize the annuity gain of the decedent in the year of transfer. Maybe an example will help clear up the confusion...

1. Father takes out an annuity and has a basis of $25,000.
2. Annuity is worth $100,000 as of Father's death.
3. Father leaves annuity to Son.
4. Son may reinvest or leave the annuity over a 5-year dispersal plan, or plan of certain # years if he
does so in a timely fashion. The annuity may continue to have future earnings tax deferred, but the
new basis is $100,000 and the basis belongs to the son.
5. Even if son reinvests as described in 4. above, he still must report his father's $75,000 gain as income
on his tax return for the year the annuity is transferred to him.

Do I have it correct? In other words, NOTHING can prevent the $75,000 from becoming income this year?
There is no escape from the $75,000 income?

Sorta like an old "Argonauts" movie I remember from my youth: "Against the children of the Hydra's teeth, there
is no defense!"

Sorry for my part of the confusion...