IRD Rules for Annuities

[appelman]

I stand corrected, up to a point.

A LUMP SUM DISTRIBUTION is treated as IRD. "The distribution is taxable in the year received as income in respect of a decedent up to the decedent's taxable balance." But I am strongly convinced that any other distribution -- distribution over 5 years or less or annuitization -- will be taxable AS IT IS RECEIVED. I will remain so convinced until someone provides a cite that clearly refutes this conviction. The PLR that NYEA cites doesn't do the job. As I see it, income is not "includible in gross income" until it is received (or possibly accrued, for an accrual-basis taxpayer). I really can't think of any situation in which a properly deferred retirement distribution is taxable before it is received.

[Snaggletooth]

Not a Retirement Account

I really can't think of any situation in which a properly deferred retirement distribution is taxable before it is received.

I can't either if the annuity is in a retirement account. Different rules apply in a qualified retirement account.

In its most general sense, an annuity is purely an investment and is not in a retirement account (although it CAN be). Someone can invest $25,000 in an annuity simply as an investment, and have it accumulate tax free until such time as cashed out or death.

I have one client, a widow, with over $1,000,000 tied up in a half-dozen of these annuities. Has nothing to do with her husband's retirement, or hers either. She has no children for beneficiaries, so for estate planning purposes, I have advised her to leave them to two of her favorite colleges, in which case NO ONE will have to pay income taxes on them. They will, however, be part of her taxable estate.

[appelman]

For "retirement distribution" read "distribution from an annuity."

To summarize: At the moment, NYEA thinks the 5-year option doesn't exist, Snag thinks it exists, but the entire taxable part of the annuity is taxable to the beneficiary as IRD at the time (s)he inherits the annuity, and I think (and I believe Roland may agree) that it is taxable as it is distributed. We obviously need chapter and verse. Lacking that, we seem stuck here. I'm going to try to post the issue on another forum and see if we can develop more light and less heat.

[Roland Slugg]

I would also like to summarize:

1. Snag posed a question, presumably because he did not know the answer that question.
2. Three different people have posted replies that, with minor, inconsequential variations, are all fundamentally similar.
3. Snag disagrees with all the advice offered so far, insisting that the "income" portion of the annuity is fully taxable in the year of death.
4. It was also suggested that Snag can ask the insurance company itself, but he doesn't want to do that either.

Do I have that about right, Dude?

This begs the question, why did you solicit advice in the first place, Buck-O???

Before giving up on this post I will just say ... one more time ... that the beneficiary has two options: (1) she can take the funds in any amounts over five years (which includes a 100% lump sum distribution), or (2) she can "stretch" the payments out over her own life expectancy, or any fixed, shorter period, as long as she takes the first distribution within one year after the decedent's date of death. (Code §72(s)(2)) If the distributions are spread out over two or more years, the deferred income will be similarly spread out. A simple call to the insurance company would elicit the same advice, and the information received would be authoritative.

And now, as Seinfeld's Kramer would say, "I'm d-d-d-d-d-done!"

[New York Enrolled Agent]

To summarize: At the moment, NYEA thinks the 5-year option doesn't exist, Snag thinks it exists, but the entire taxable part of the annuity is taxable to the beneficiary as IRD at the time (s)he inherits the annuity, and I think (and I believe Roland may agree) that it is taxable as it is distributed.

I think it best if posters state their own opinions and not try to categorize the opinions of others.

IRD is defined in §691. The issue addresssed in letter ruling 200041018 is whether the gain from the annuity received by the beneficiary constitutes IRD. The answer is YES.

The question then arises - when is the IRD recognized as income? The general rule for recognizing income is found in
§451. A careful reading of the above referenced letter ruling actually gives the answer. A snip - "We conclude that the payment of the death benefit to Beneficiaries under the Contract upon the death of X will constitute income in respect of a decedent (IRD) within the meaning of section 691(a)(1)(B) when distributed to the beneficiaries, to the extent such payment exceeds X's investment in the Contract."

If Snag's client has received a lump sum in 2012, the IRD will be fully reported in 2012. If the client has opted for a different payment option, then the IRD will be reported as income as received. One of the possibilities is the default 5 year option in §72(s) - written as an annuity requirement . An other is the installment option which is not restricted to 5 or any other number of years. Of course, you could do 5 years - but you are NOT restricted to that.

I believe Snags was concerned that 60 days had gone by and the client had not yet made a decision. The lack of a choice appears to run afoul of §72(h). However, Snags - I believe many commentators now feel that §72(s) trumps §72(h) and that you have one year (as stated in §72(s)) to make an investment option. §72(s) was enacted later than 72(h) and §72(s) was enacted to provide that no contract issued after 1/18/85 would be considered an annuity unless the distribution provisions as noted in previous posts were part of the contract. If your client has not yet taken a lump sum, I would propose you tell them to set up a payment plan of their choosing. This way the $75,000 of IRD gain (as you referenced) would be spread out over the payment schedule. Like R.S., this is my final post on this topic.

[Snaggletooth]

For Respondants

Thanks to all respondants for their time, expertise and patience - Snag

[Burke]

I am going to jump in here and posit that yes, $25K is basis and $75K is taxable earnings. But the only time the entire $75K would be reported on the son's tax return is if he takes a total distribution in a lump sum. Otherwise, the taxable part would be as he receives the proceeds in whatever election he decides to make, in the same ratio of basis to earnings as the figures were as of the owner's death. A full and complete tax-deferred "rollover" is what he is not allowed to do for a non-qualified annuity. Just for general information, annuities themselves do not receive stepped-up basis at death.


PS: I posted this without realizing there were numerous responses on the 2nd page, with which I agree, (see NYEA.). I am leaving it as is since it stipulates an additional point.