Advanced Underwriting Consultants

Question of the Day – October 5

Ask the Experts!

Here’s the question of the day.

Question:  My client owns a deferred annuity.  She will turn 59 ½ later in this calendar year.  If she takes a taxable withdrawal now, is she subject to the penalty tax?

Answer:  Yes.  Early taxable distributions are subject to the 10% penalty tax unless a specific exception applies.  The age 59 ½ exception is strictly construed.

Here’s the critical language from Revenue Code Section 72(q):

    (q) 10-percent penalty for premature distributions from annuity
        contracts
      (1) Imposition of penalty
        If any taxpayer receives any amount under an annuity contract,
      the taxpayer's tax under this chapter for the taxable year in
      which such amount is received shall be increased by an amount
      equal to 10 percent of the portion of such amount which is
      includible in gross income.
      (2) Subsection not to apply to certain distributions
        Paragraph 1 shall not apply to any distribution -
          (A) made on or after the date on which the taxpayer attains
        age 59 1/2,

The interpretation is the same for taxable distributions from an IRA or other qualified plan.  Here’s the IRS’s explanation of the penalty tax from Publication 590, which applies to IRA distributions:

Generally, if you are under age 59½, you must pay a 10% additional tax on the distribution of any assets (money or other property) from your traditional IRA. Distributions before you are age 59½ are called early distributions.

The 10% additional tax applies to the part of the distribution that you have to include in gross income. It is in addition to any regular income tax on that amount.

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 – September 28

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 client recently passed away, leaving a deferred annuity to a nonspouse beneficiary.  Is the annuity subject to both estate taxes and income taxes?

Answer: Yes.

The gain portion of a nonqualified annuity is potentially subject to both income tax and estate tax.  This occurs because the gain is considered income in respect of a decedent.  Income in respect of a decedent (IRD) is property which the decedent had a right to receive during life and would have been included in gross income if so received.  Taxation of IRD is governed by Section 691 of the IRC.

To soften the blow of the potential double taxation, a deduction is allowed on the beneficiary’s income tax return for the amount of estate tax paid which was attributable to inclusion of the taxable gain in the decedent’s gross estate.  The amount of the deduction is determined by comparing the actual estate tax paid to a hypothetical estate tax calculation made without including the gain in the contract.

For example, assume Mother dies with an estate subject to estate tax.  Among her property is a non-qualified deferred annuity with cash value of $200,000, for which she paid a premium of $100,000.  Suppose Mother’s estate pays an estate tax of $1 million.  Say also that if the estate tax had been calculated excluding the gain in the contract, the estate tax would have been only $961,000.  The difference, $39,000, is allowable as a deduction on the beneficiary’s return.

Thus, the beneficiary, Daughter, receives $200,000, lists $100,000 as taxable income, and takes a deduction of $39,000.  Effectively, she pays tax, at her marginal bracket, on $61,000.

What if Daughter chooses to take a settlement option rather than a lump-sum?  If she receives $15,000 in the first year and its determined this consists of $10,000 return of premium and $5,000 taxable gain, then she would take a deduction of $5,000/$100,000 x $39,000 or $1,950.  The formula, in words, is taxable gain distributed divided by total taxable gain included in estate times allowable deduction.  Each year this step would be repeated until the allowable deduction is exhausted.

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.