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.

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