When an annuitant dies before receiving the full amount guaranteed under a refund or period-certain life annuity, the owner or beneficiary receiving the balance of the guaranteed amount will have no taxable income (unless the amount received by the beneficiary plus the amount that had been received tax-free by the annuitant exceeds the investment in the contract).
If the refund or commuted (present) value of the remaining installments is applied by the owner or beneficiary to purchase a new annuity, payments received will be taxed under the annuity rules to the beneficiary. The insurer will consider the refund amount to be the beneficiary’s investment in the new contract and the insurer will determine a new exclusion ratio. This option often is selected if the guaranteed refund amount will exceed the unrecovered investment in the contract and would otherwise create a partially taxable lump-sum payment.
If the owner was receiving payments under a joint and survivor annuity, the surviving owner excludes from income the same percentage of each payment that was excludable by the first annuitant (assuming that the joint annuitants were joint owners). An income tax deduction may be available to the survivor owner/annuitant to the extent inclusion of the annuity in the estate of the first to die generated an estate tax (under the rules for income in respect of a decedent).
If an annuitant dies before payments received equal cost, the owner can take a loss deduction for the amount of the unrecovered investment, provided the annuity starting date was after July 1, 1986. So if a wife purchases a single premium nonrefundable annuity (whether on her own life, or alternatively on the life of her husband), and the annuitant dies before all costs have been recovered, a loss deduction will be allowed.
The deduction for the unrecovered investment in the contract is an itemized deduction, but not a miscellaneous deduction. Therefore, it is not subject to the 2 percent floor. If the decedent/annuitant is the owner, the loss is taken on the decedent’s final return and will be treated as a business loss, eligible to be carried back if the loss exceeds the income shown on the decedent’s final return. Otherwise, if the owner is not the decedent/annuitant, the owner takes the loss on his tax return. In addition, these deductions can ultimately be taken by the estate or any other beneficiary that receives post-death payments.
The 10 percent premature distribution penalty tax does not apply to required after-death distributions.
Payments to Beneficiaries
Amounts payable under a deferred annuity contract at the death of an annuitant (prior to the contract’s maturity) will be partially taxable as ordinary income to the beneficiary. The taxable amount is equal to the excess of: (a) the death benefit (plus aggregate dividends and any other amounts that were received tax-free); over (b) total gross premiums.
Beneficiaries can elect to delay reporting of the gain in the year of the annuitant’s death if the beneficiary applies the death benefit under a life income or installment option within sixty days of the annuitant’s death. The beneficiary will then report income according to an exclusion ratio. The beneficiary’s investment in the contract will be the same as the annuitant’s investment in the contract. The expected return is based on the income the beneficiary will receive and the beneficiary’s life expectancy.
If an annuity owner dies before the starting date of the annuity payments, the cash value of the contract must either be distributed within five years of death or used within one year of death to provide a life annuity or installment payments payable over a period not longer than the beneficiary’s life expectancy. However, if the surviving spouse is the beneficiary, the spouse can elect to become the new owner of the contract instead of selecting one of the above options.
If the annuity contract is transferred by gift, the tax deferral on the inside build-up—which was allowed to the original contract owner—is terminated. The donor of the gift is treated as having received nonannuity income in an amount equal to the excess of the cash surrender value of the contract over the investment in the contract at the time of the transfer. The recipient of the gift will take a new basis in the contract equal to the donor’s investment in the contract, plus the amount of gain recognized on the gift (note that the new basis, the sum of the donor’s basis and the donor’s investment in the contract, is generally equal to the fair market value of the contract).
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM