Ask the Experts!

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 46 year old client is making a $100,000 after-tax cash deposit into an immediate annuity from a carrier that permits a delayed beginning date.  If my client chooses to delay the first payment for six years, and takes a five year certain annual payout, how will the annuity payments be taxed?

Answer: For an immediate annuity, payments are treated in part as a tax free return of basis, and partly a taxable distribution.  For a five year certain annuity, each payment would be recapture one-fifth of the basis every year.  That would mean $20,000 would be tax free, and any additional annual payment would be subject to ordinary income tax.

Normally, the taxable portion of an immediate annuity payment is not subject to the 10% pre-59 ½ early distribution penalty.

However, just because an insurance company calls its product an immediate annuity doesn’t mean that it is.  Code Section 72(u)(4) defines “immediate annuity” and contains the requirement that the payments commence within one year of premium payment.

Under the facts described, we believe the contract would be treated as a deferred annuity for the five year period and then when payouts begin, it would then be treated as an immediate annuity.  That means that the payments would get the kind of exclusion ratio treatment described above.

However, because the annuity payout period would have to involve life expectancy to avoid the 59-/12 penalty as long as the client is under 59-1/2.

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