Advanced Underwriting Consultants

Ask the Experts – May 30

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: My client’s mother passed away on July 10, 2009. My client inherited her mother’s nonqualified annuity but has failed to take any distributions from it since she inherited it. Is it too late to make a stretch election, or must she fully distribute the annuity within 5 years? What are the penalties if she fails to fully liquidate the annuity within 5 years?

Answer: There are multiple issues, but we’ll start with the basic rule. Under Code Section 72(s), an inherited annuity must either be stretched based on the life of the beneficiary or fully distributed within 5 years.

First, it’s not clear when the 5-year period starts. The language in the tax code indicates that the beneficiary must withdraw all the funds by fifth anniversary of the original owner’s death, which would be July 10, 2014 for your client. However, some carriers might interpret this rule to mean 5 years from the end of the year in which the person died—December 31, 2014, for your client. Therefore, your client should has until July 10, 2014, to fully distribute the annuity, but she should check with the carrier first.

Assuming the carrier interprets the 5-year rule to be from the date of death, your client will have no choice but to liquidate the annuity by July 10, 2014, because that’s written in the annuity contract. That is, the life insurance company will distribute the funds from the nonqualified annuity by July 10 whether your client wants the money or not.

Finally, your client must have elected to stretch within one year from her mother’s death, which was on July 10, 2010, if she wanted to stretch out the nonqualified annuity payments based on her life expectancy. Unlike with IRAs, there are no exceptions.

The tax code is not clear as to the timing of distributions when a beneficiary elects to stretch. Section 72(s) only requires that the annuity be distributed “over the life of such designated beneficiary,” so it’s best to check with the carrier to figure out how it handles these types of elections.

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Question of the Day – August 3

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Here’s the question of the day.

Question: How are distributions from an annuity with a special extended income account taxed?

Answer: Withdrawals from a nonqualified deferred annuity (NQDA) are taxed on a gain-first basis.  Gain is measured by subtracting the owner’s basis in the contract from the policy’s gross cash value.  A taxable distribution may be subject to the 10% penalty tax if the owner of the contract is younger than age 59 ½.

Once all the gain is distributed, the distribution is a tax-free return of the policy owner’s basis.

Some new NQDA designs have an enhanced withdrawal account.  That feature allows the policy owner to draw additional income from the annuity, even if the policy’s cash value is zero.  So what happens, tax-wise, after all the gain and all the basis has been recovered, and there is still value left in the policy?

The short answer is that we do not know for sure.  The IRS has not given us reliable guidance with regard to the new contract designs.  The likeliest result, in our opinion, is that distributions taken after both gain and basis have been fully drained from the NQDA is that distributions will be fully taxable once again.

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Question of the Day – August 2

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Here’s the question of the day.

Question: My client has a nonqualified annuity owned by his trust, and he is the current annuitant.  He wants to change the annuitant to his wife.  Is that an income taxable event?

Answer: It’s not easy to tell, in part because the rules are unclear, and in part because it probably depends on the way the trust is written.

A change in ownership of a nonqualified annuity contract from one spouse to another is a nontaxable transfer under Code Section 1041.  In its explanation of DEFRA in 1984, Congress implied that transfers in trust for the benefit of a spouse are also covered by the Section 1041 non-taxation rules.  See page 711 of the document at this link:  https://www.jct.gov/publications.html?func=startdown&id=3343.  Other transfers of annuity contracts are treated as taxable dispositions.

What is the purpose behind non-recognition of gain on spousal transfer, but recognition for other transfers as taxable?  We think it’s because Congress doesn’t want the NQDA date of tax reckoning to be put off forever.  In theory, if family members made pre-death gifts of an annuity, in the absence of the non-spouse transfer rule they’d put off recognition of taxable gain forever.  Congress assumed that spouses are of the same generation—as they did with the unlimited marital deduction for estate taxes or spousal continuation for NQDA death benefits—and so carved out an exception for tax recognition for transfers between spouses.

So, if that analysis is correct, what does it mean for the fact situation?

Where a non-natural person, such as a trust, owns an annuity contract, the annuitant’s death controls when the annuity must be distributed.  If you can change the annuitant without a tax result, the day of tax reckoning can be put off forever.  So under normal circumstances, a change in annuitant for a trust-owned NQDA must be treated as a taxable disposition.

Does the transfer qualify for the Section 1041 spousal transfer exception.  If both husband and wife are the sole beneficiaries of the trust while either is alive, then under the facts provided the Section 1041 exception probably applies.  If, on the other hand, the trust is written in a different way—with family members other than the spouses being permissible or mandatory beneficiaries, for example–the change in annuitants is probably an income taxable event.

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Question of the Day – February 22

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client has used his nonqualified annuity (NQDA) as security for a bank loan.  Does that create any tax problems?

Answer: Yes.  If an NQDA is used as security for a loan, the loan will be treated as a taxable distribution from the annuity.  Likewise, for a modified endowment contract (MEC) life policy, a security interest against the policy is a taxable distribution.

Here’s an excerpt from Revenue Code Section 72, which describes how loans against NQDAs are taxed.

    Loans treated as distributions
      If, during any taxable year, an individual -
        (i) receives (directly or indirectly) any amount as a loan
         under any contract to which this subsection applies, or
       (ii) assigns or pledges (or agrees to assign or pledge) any
         portion of the value of any such contract,
        such amount or portion shall be treated as received under the
        contract as an amount not received as an annuity.

“Amounts not received as an annuity” from an NQDA are taxed on a gain-first basis.

Under Code Section 72, MECs subject to an assignment are taxed the same way as NQDAs.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – February 10

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client bought two nonqualified deferred annuities (NQDAs) in 2001 from the same life insurance company.  She paid $5,000 for the first annuity, and $20,000 for the second one.  She surrendered the first NQDA for its $8,000 surrender value in 2011. She received a Form 1099 from the insurance company showing that all $8,000 she received is taxable.  That seems wrong—only the gain portion of $3,000 should be taxable.  Do you agree?

Answer: No.  Unfortunately for your client, there is a special rule built into the tax code that aggregates two NQDAs purchased in the same year for the purpose of figuring gain.

Here’s an excerpt from Code Section 72(e)(12):

(12) Anti-abuse rules

(A) In general

For purposes of determining the amount includible in gross income under this subsection –

(i) all modified endowment contracts issued by the same

company to the same policyholder during any calendar year

shall be treated as 1 modified endowment contract, and

(ii) all annuity contracts issued by the same company to

the same policyholder during any calendar year shall be

treated as 1 annuity contract.

Therefore, in this case, the gain in both NQDAs purchased by the client from the same company in 2001 would be aggregated.  If the gain for both contracts added up to be $8,000 or more, the entire $8,000 received from the surrender of the one contract would be taxable.

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Question of the Day – December 21

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Here’s the question of the day.

Question: My client has a $200,000 basis in an NQDA worth $400,000.  The client wants to get $200,000 out of the NQDA to buy a house.  Under the rules, the entire $200,000 distribution will be taxable and subject to the penalty tax if the client is younger than 59 ½.

I want to know if the client does a partial 1035 exchange of the NQDA—sending half to a new contract—will the client effectively be able to avoid income taxes on half of the $200,000 left in the existing NQDA?

Answer: The short answer is no, based on the information in Revenue Procedure 2011-38.  If the client can wait for six months to take a distribution after the partial exchange, the strategy might work.  I’ve included a description of Revenue Procedure, along with a prior relevant Revenue Procedure, below.

Revenue Procedure 2008-24 superseded Notice 2003-51 and gave additional guidance on what partial exchanges will be considered valid tax-free exchanges.  It stated that a valid transfer would be one in which no distributions would be taken from either contract within a year of the exchange.

Rev. Proc. 2008-24 says that if a distribution is taken too soon, the whole Section 1035 transaction fails.

Here’s an example.  Say the exchange outlined above takes place–$100,000 cash value contract, $50,000 basis, is split into two equal contracts.  The taxpayer also makes a $10,000 withdrawal within 12 months of the split.  Under Rev. Proc. 2008-24, if the $10,000 withdrawal is made within 12 months–and none of the life events apply–then the exchange is treated as invalid, and taxes and penalties would be due on the entire $50,000 gain.

Rev. Proc. 2011-38 changed the 2008 Procedure in the following ways:

1.The 12-month waiting period was shortened to 180 days.

2. The limitations upon withdrawals within 180 days no longer apply to partial annuitizations as long as the annuity period is for ten years of more, or is based upon the life of one or more persons.

3. Transfers failing to meet the 180 day waiting period will not automatically cause the partial exchange amount to be treated a taxable distribution under Code Section 72(e).

Revenue Procedure 2011-38 is effective for transfers taking place on or after October 24, 2011.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

 

Question of the Day – December 6

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My client took a distribution from her nonqualified deferred annuity (NQDA) and now wants to re-deposit it into the contract.  She hopes to avoid an income tax result on the distribution.  I’ve worked with one carrier that will treat money re-deposited within 30 days as never having been distributed for Form 1099 purposes.  However, the current carrier insists that they will issue a Form 1099 showing a taxable distribution.  Who is right?

Answer: If the annuity were an IRA, the client would generally have 60 days to re-deposit the money into the same contract and avoid an income tax event.  That procedure is sometimes referred to as a 60 day rollover.

NQDAs do not have any equivalent tax-free re-deposit window.  The IRS has consistently taken the position that once the taxpayer receives a distribution from a NQDA, the taxpayer recognizes the income tax result associated with the distribution.

The second carrier’s approach to Form 1099 reporting purposes seems correct.  Even though the first carrier does not issue a Form 1099 when money is re-deposited, it still seems like the distribution is taxable.

The IRS maintains that it’s the taxpayer’s responsibility to report taxable income correctly, even where other parties do not.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – November 17

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My 50 year old client is in the process of getting divorced.  Her husband is a participant in a 401K plan.  They’ve worked out a deal for the husband to transfer $100,000 from the plan to her, pursuant to their divorce.  What are the tax implications?

Answer: Under normal circumstances, the husband would have to pay income taxes on the plan distribution, plus any applicable penalty tax.  To avoid that tax result, the parties should divide the plan pursuant to a qualified domestic relations order (QDRO).

A QDRO is a judgment, decree, or order that relates to the provision of child support, alimony, or property rights to a spouse, former spouse, child or other dependent.  There are a few other technical requirements.

A QDRO cannot provide an alternate payee with any form of benefit not otherwise available to the plan participant.

A direct distribution from a pension to the non-participant spouse pursuant to a QDRO is taxable but not subject to the pre-59 ½ 10% penalty tax.  If that’s done in the example above, the wife would pay income tax on the 401K balance she receives, but not the penalty tax.

The alternate payee can also roll over the QDRO distribution to her own IRA tax-free.  If the rollover is done, the receiving spouse loses the ability to get penalty tax free pre-59 ½ distributions.

A QDRO-like opportunity also exists for an IRA to be split and rolled over by the non-participant spouse tax-free to his or her retirement account.  However, if an alternate payee of an IRA who is younger than 59 ½ decides to keep the distribution, the payee will be potentially liable for both income tax and penalty tax.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – November 4

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Here’s the question of the day.

Question: I have a 50 year old client who is disabled, and needs to take distributions from his IRA and nonqualified deferred annuity (NQDA) for living expenses.  Are the taxable distributions subject to the 10% penalty tax?

Answer: Distributions from the IRA are probably penalty tax free, while the penalty tax may apply to the taxable NQDA distributions depending on the timing of the disability.

Section 72 of the Internal Revenue Code says that early distributions from an IRA or a NQDA are subject to a 10% penalty tax.  There are also situations where a taxpayer can avoid the imposition of the penalty tax.  The exceptions are listed in Section 72(t) for IRAs, and 72(q) for NQDAs.

Code Section 72(q)(2)(C) says that distributions from a NQDA attributable to the taxpayer’s “becoming disabled” are not subject to the penalty tax.  That differs from the exception language in 72(t), which applies to distributions attributable to the taxpayer’s “being disabled.”

Did Congress mean for the penalty tax disability exception to be different for IRA and NQDA distributions?  For NQDAs, does the disability exception only apply to distributions where the taxpayer became disabled after the contract was purchased?  The IRS hasn’t said for sure.

If the IRS decides to impose a strict interpretation on the NQDA disability exception, then a taxpayer who takes a taxable distribution and who was already disabled at the time of the contract purchase, the 10% penalty tax would apply in most cases.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.