A—"Amounts Received As An Annuity"

Internal Revenue Code §72 governs the income taxation of
annuity contracts. In general, Code §72 provides that amounts received from
annuity contracts are includable in gross income except to the extent such
amounts are considered to represent a reduction or return of premiums or other
consideration paid. For purposes of determining whether amounts received
represent a reduction or return of premiums or other consideration paid, Code
§72 differentiates between "amounts received as an annuity" and
"amounts not received as an annuity". Amounts not received as annuities
include policy dividends, returns of premiums, payments in full discharge of
the issuer`s obligation under the contract which are in the nature of a refund
of the consideration, lump sum payments upon surrender redemption or maturity
of the contract, and partial withdrawals from annuity contracts.

This Subdivision A covers the taxation of "amounts
received as an annuity".

Subdivision
B covers the taxation of "amounts not received as an annuity".

Taxation Of Annuity Income ("Amounts Received As An
Annuity")

The objective is to determine which portion of each periodic
annuity payment constitutes a return of capital and which part is interest
income. Only the latter is taxed. The portion of each periodic payment that is
considered a return of capital is excluded from gross income.

General Rules For Fixed Annuities

Annuity Exclusion Ratio

A fixed fraction of the guaranteed periodic payments under an
annuity contract is considered return of capital. This fraction is called the
exclusion ratio. The exclusion ratio equals the investment in the contract
divided by the expected return [I.R.C. §72(b)].

Contract
Investment

-----------------------------
= Exclusion Ratio

Expected Return

The exclusion ratio is determined at the time annuity
payments first begin ("the annuity starting date") and is applied to
each payment as follows:

Exclusion Ratio x Annuity Payment = Amount Excluded
From Taxable Income

The amount excluded from taxable income represents the
portion of the annuity payment that is considered a return of capital. The
remaining portion of the payment represents the interest element and is taxable
[I.R.C. §61(a)(9)].

Annuity Starting Date On Or Before

If the annuity starting date was on or before December 31,
1986, the exclusion ratio remains constant throughout the annuitant`s lifetime.
An annuitant who outlives his or her life expectancy will continue to exclude a
portion of each payment from gross income even after recovering the full
investment in the contract. Conversely, no deduction is allowed for the
unrecovered investment of an annuitant who dies before recovering the
investment in the contract.

Annuity Starting Date After

If the annuity starting date is after

Expected Return

Expected return (the denominator of the exclusion ratio) is
the total amount the annuitant can expect to receive under the annuity
contract. If payments are for a fixed period or a fixed amount with no life expectancy
involved, expected return is the sum of the guaranteed payments. Code
§72(c)(3)(B) Reg. §1.72-5(c). If payments are to continue for a life or
lives, expected return is determined by multiplying the sum of one year`s
annuity payments by the life expectancy of the measuring life or lives using
annuity tables prescribed by the IRS. Code §72(c)(3).

The expected return under an annuity contract is determined
as of the "annuity starting date." The annuity starting date is
defined as the "first day of the first period for which an amount is
received as an annuity" [Reg. §1.72-4(b)].

Investment In The Contract

The investment in the contract is determined as of the later
of the annuity starting date (defined above) or the date on which an amount is
first received under the contract as an annuity [Reg. §1.72-6(a)(1)].

The investment in the contract equals:

a.
a. the aggregate amount of premiums
or other consideration paid for the contract,

b.
b. less amounts received under the
contract that were excludable from gross income [I.R.C. §72(c)(1); Reg.
§1.72-6(a)(1)].

Annuity Tables

The life expectancies used to determine expected returns are
taken from annuity tables prescribed by the IRS [Reg. §1.72-9]. There are two
sets of tables. Tables I through IV (the "gender-based tables") are
based on 1937 mortality data and set forth separate return multiples for men
and for women, with longer life expectancies for women. Because of this
distinction in the gender-based tables, a woman could not exclude as high a
proportion of an annuity payment as a man of the same age.

Tables V through VIII (the "unisex tables") are
based on 1983 mortality data and do not distinguish between men and women.
Under the unisex tables, exclusion ratios for men and women of the same age
will be identical. However, because life expectancies increased between 1937
and 1983, both men and women will be taxed on a greater portion of annuity
payments under the unisex tables.

The tables used to determine the expected return for a
particular annuity will depend on (1) when the investment in the contract was
made and (2) the annuity starting date:

1. 1.
If all investments in the contract were made before

2. 2.
If all investments in the contract were made before July 1, 1986, and
the annuity starting date was after June 30, 1986, the annuitant has the option
of using either set of tables if the contract does not provide for any option
(whether or not exercised) to receive a disqualifying form of payment. A
disqualifying form of payment is any form of payment except a life annuity,
e.g., a lump sum payment, payments for a period certain or a refund feature
that is substantially equivalent to an annuity for a period certain. An option
to choose between alternative forms of life annuity (e.g., a choice between a
single life annuity and a joint life annuity) is not a disqualifying option.

3. 3.
If all investments in the contract were made before July 1, 1986, and
the annuity starting date was after June 30, 1986, the unisex tables must be
used if the contract provides for any option (whether or not exercised) to
receive a disqualifying form of payment.

4. 4.
If investments in the contract were made both before July 1, 1986, and
after June 30, 1986, and the contract does not provide for any disqualifying
form of payment, the annuitant has the option of using the unisex tables for
all payments or of computing separate exclusion ratios, using the gender-based
tables for investments before July 1, 1986, and the unisex tables for
investments after June 30, 1986.

5. 5.
If investments in the contract were made both before

6. 6.
If all investments in the contract were made after

Since almost all annuity contracts provide an option to
receive payments in some form other than a life annuity the unisex tables will
apply to most contracts with annuity starting dates after

The annuity tables are reproduced in Section 17. You may wish
to refer to these tables to follow the sample calculations below.

The following example will illustrate how an exclusion ratio
is calculated and how it will be affected by use of the unisex tables. A man
aged 61 (nearest birthday) bought an immediate life annuity in 1984. The single
premium was $55,680 and the monthly annuity payments total $4,000 per year.
Because the investment in the contract and the annuity starting date are before

Assume that the same man has a brother two years younger who
bought an identical annuity at age 61 after

In this computation, a short-cut is possible. Actually, the
exempt portion of the annual payment does not depend upon the size of the
payment at all. To find the exempt portion quickly, divide the total investment
by the annuitant`s life expectancy.

To verify this short-cut, express the general rule as a
fraction. The numerator becomes total investment times the annual payment; the
denominator is expected total return (the annual payment times the annuitant`s
life expectancy). Canceling the annual payment from both numerator and
denominator, we have the short-cut.

Thus, in the illustration, the excluded portion of the first
brother`s annual payments might have been quickly found by dividing $55,680
(the total investment) by 17.5 (the annuitant`s life expectancy).

Ordinarily, the short-cut affords the simpler computation.
However, the statutory method becomes of value when payments are made
semiannually, quarterly or monthly, and a full year`s annuity payments are not
received in the first year. Moreover, the short-cut may produce a variance of a
few cents, since in the statutory method the quotient of total investment and
expected total return is officially carried to only three decimal places [Reg.
§1.72-4(a)(2)].

Dividends

Dividends received before the annuity starting date that were
excluded from gross income represent return of capital, and since they
reduce total investment in the contract, the effect is to lessen the tax-exempt
fraction of the guaranteed annual payment. [I.R.C. §72(e)(1)(B); Reg.
§1.72-11(b)(1)]. On the other hand dividends left on deposit as of the annuity
starting date become part of the investment in the contract (the numerator of
the exclusion ratio). [I.R.C. §72(e)(1)(A); Reg. §1.72-11(b)(2)]

Annuity With Refund Feature Or Period-Certain Guarantee

Annuity Starting Date After

For individuals whose annuity starting date is after December
31,1986 a 1996 tax law change provides that, for purposes of determining the
exclusion ratio that applies to amounts received as an annuity, the taxpayer`s
investment in the contract, as of the annuity starting date, will not be
reduced by the value of the refund feature or period certain guarantee [I.R.C.
§72(b)(4)(A)]

Annuity Starting Date Before

For individuals whose annuity starting date is before December
31, 1986 the amount of the taxpayer`s investment in the contract is reduced by
the value of the refund feature or period certain guarantee. To determine the
exempt portion of each annual payment the annuitant receives, divide his
adjusted (not total) investment by expected total return, and multiply this
quotient by the annual payment.

Adjusted investment equals total investment less a refund or
period-certain adjustments, which is the net actuarial value of the refund or
period-certain feature, calculated as of the annuity starting date. [I.R.C.
§72(c)(2)]. This refund adjustment depends upon the actuarial probability of
the annuitant`s dying during the guaranteed period.

To find a refund adjustment, proceed in the following manner:

1.
1. Find the total amount guaranteed
as of the annuity starting date, and divide this amount by the annual annuity
income. The quotient represents the number of years` payments guaranteed.

2.
2. Round this quotient off to the
nearest whole number.

3.
3. With this number and the
annuitant`s attained age, find the appropriate percentage on Table III or Table
VII, whichever is applicable.

4.
4. Compute this percentage of either
(a) total investment, or (b) total amount guaranteed, whichever is less. The result
is the refund adjustment.

For a period-certain adjustment, steps (1) and (2) above are
unnecessary. Take the number of years in the period-certain, and proceed with
steps (3) and (4).

For example, a man aged 60 buys for $17,490, a single-premium
refund annuity, which will pay him $1,000 a year. To find his adjusted
investment, divide the total amount guaranteed (17,490) by the annual payment
($1,000). Round off the quotient (17.49) to the nearest whole number (17). Then
enter Table III in the regulations and find the pertinent factor (20 percent).
Take this percentage of either total investment or total amount guaranteed,
whichever is less (both here are $17,490) . Upon subtracting the result
($3,498, the refund adjustment) from the total investment (17,490), we obtain
the adjusted investment ($13,992). Next multiply the annual payment ($1,000) by
the man`s adjusted life expectancy (17.7 years). The product ($17,700) is his
expected total return. Then divide his adjusted investment ($13,992) by this expected
total return ($17,770), and multiply the quotient (.791) by the annual payment
($1,000). This product, $791, is exempt from tax each year; the balance of each
$1,000 payment, $209, is reportable income. (Alternatively, under the
short-cut, $13,992 ÷ 17.7 years = $791 a year excludable.)

Refund Or Period-Certain Beneficiary

The beneficiary of the refund or period-certain feature
realizes gross income only to the extent that the payments plus the exempt
amount paid to the annuitant exceed the sum paid in premiums [I.R.C.
§§72(e)(1)(B) and 72(e)(2)(A)]. Thus, payments to a beneficiary are tax-free
until the sum of all exempt payments exceeds the total consideration.
Thereafter, all amounts received are fully taxable. This rule applies whether
payment is made in one sum or in installments, provided the beneficiary cannot
receive more than the amount guaranteed at the annuitant`s death. If the
beneficiary can receive more, the beneficiary will determine a new exclusion
ratio to such payments as if they were provided under a new contract received
in exchange for the contract providing the original annuity payments [Reg.
§1.72-11(c), (e)].

The beneficiary`s reportable income from the annuity
qualifies as income in respect of a decedent, to the extent it represents the
excess of the death value over net premiums paid. Hence, the beneficiary may be
entitled to an income tax deduction for estate tax paid [I.R.C. §691(d); Reg.
§1.691(c)-1; I.T. 3744, 1945 CB 192].

Temporary Life Annuities

Some annuity contracts provide for fixed periodic payments
for a specified number of years or until the annuitant`s death, whichever
occurs earlier. This type of contract is known as a temporary life
annuity. The income tax treatment of payments received follows the same
basic principals as with other annuity contracts (i.e., an exclusion ratio is
computed and applied to each payment received), however, the denominator in the
ratio computation, the expected return, must be determined through use of an
Annuity Table, since it will depend upon the annuitant`s life expectancy.
Annuity Tables IV (gender-based, for contracts in which no investment was made
after

Joint And Survivor Annuities—Level Payments

There are two basic types of joint survivor annuity
contracts. With one, the insurance company pays the survivor the same amount as
it paid the two annuitants while both were alive. With the other, the company
pays the survivor a lesser amount. Let us consider first the level-payment
type. The basic principals for income taxation of annuities are
applicable: an exclusion ratio is determined and applied to each payment
received. Assuming that there is no change in the fixed periodic payment
amount after the death of the first to die, the payments received by the
survivor will continue to be subject to the same exclusion ratio and same
income tax treatment as when the payments were made to the two annuitants
jointly. In computing the exclusion ratio, the denominator (the expected
return for the duration of the annuity) must be determined by reference to
annuity Tables specifically provided for joint and survivor annuities.
The tables are accessed by reference to the ages of both of the joint
annuitants. Gender-based Table II is used for contracts in which no
investment was made after June 30, 1986 and unisex Table VI is used for those
having post June 30, 1986 investments. The factor derived from the table
is then multiplied by the total payments to be received in a one year period,
and the product is the "expected return" for purposes of the
exclusion ratio computation.

Joint And Survivor Annuities—Reduced Payment To 2nd Annuitant

Some joint survivor annuity contracts provide for reduction
of the annual payments when one annuitant dies. In one, the larger payments
continue until a specified annuitant dies. If the other annuitant had died
before then, the payments stop and the annuity ends. However, if the other
annuitant survives, the company pays the survivor the reduced sum each year
until death. This is often called a survivorship annuity. In the other type,
the annual payment is reduced at the first death. So long as both annuitants
are alive, the company pays the larger amount. After the first death, the
survivor receives the lesser sum annually for the balance of his or her life.
This is the familiar joint and two-thirds (or other fraction) survivor annuity.

With either type, if one annuitant died before

For both types, if neither annuitant died before

To find expected return for a survivorship annuity:

1. 1.
From Table II or Table VI in the regulations, find the annuitants`
joint-and-survivor life expectancy at the annuity starting date, and adjust
this factor for frequency of payment.

2. 2.
Multiply the adjusted factor by the smaller annual payment.

3. 3.
From Table I in the regulations, find the specified first annuitant`s
individual life expectancy at the annuity starting date, and make the
frequency-of-payment adjustment.

4. 4.
Next multiply this adjusted factor by the difference between the larger
and smaller payments.

5. 5.
Then add together the products from steps (2) and (4). The result is the
expected total return [Reg. §1.72-5(b)(2)].

To find the expected total return for a joint and two-thirds
(or other fraction) survivor annuity, proceed in the following manner :

1. 1.
From Table II or Table VI in the regulations, take the annuitants`
joint-and-survivor life expectancy at the annuity starting date, and adjust it
for frequency of payment.

2. 2.
From Table IIA or Table VIA in the regulations, find the annuitants`
life expectancy at the annuity starting date, and make the frequency-of-payment
adjustment.

3. 3.
Compute the difference between these factors, and multiply it by the
payment to the survivor.

4. 4.
Next multiply the factor from step (2) by the larger annual payment to
be received while both annuitants are alive.

5. 5.
Then add together the products from steps (3) and (4). The result is the
expected total return [Reg. §1.72-5(b)(5)].

Finally, to find the exemption portion of a given annual
payment, divide the total investment by this expected total return, and
multiply the resulting exclusion ratio by the annual payment. The product is
the exempt portion.

Example

A husband and wife, aged 65 and 60, respectively, buy an
immediate joint and survivor annuity which will pay $150 a month to them during
their joint lives, and $100 a month to the survivor. The single premium is
$30,000. The annuity starting date is before

If the couple in the above example bought an identical
annuity after

If one annuitant has died since

Joint And Survivor Annuities On Three Lives

The principles outlined in the proceeding paragraphs may be
extended to cover taxation of joint and survivor annuities on three lives. The
IRS will furnish, for any such annuity, directions and factors for computing
the excludable portion of the annual payment and the annual deduction available
to a surviving annuitant.

Joint And Survivor Annuities—Change In Payment Only If A
Specific Annuitant Dies First

The treatment of a joint and survivor annuity which provides
for a change in the fixed periodic payment only if a specific one of the two
annuitants dies first is dealt with in Reg. §1.72-5(b)(2). For example, a
husband is to receive $200 per month for life and after he dies his surviving
wife is to receive $100 per month however, if the wife dies first the payments
to the husband do not change when she dies.

Lump Sum Withdrawal After Annuity Starting Date

Even after annuitization, some contracts allow for a lump sum
withdrawal (for example, in the event of an unforeseen financial emergency),
coupled with a reduction in either the amount or the duration of the future
periodic annuity payments.

Different Duration

If an annuity is modified after the first payment, and the
new annuity has a different duration, the general rule applies but the
recipient takes a new start. The annuity starting date, investment in the contract,
and expected return are all recomputed [Reg. §1.72-11(e)]. An installment or
life income settlement chosen by an annuity refund beneficiary falls into this
category, if he or she may receive more than the original guarantee.

Same Duration; Reduced Annuity Payment

If an annuitant withdraws a lump sum, and takes a reduced
annuity with the same duration as the old one, he or she continues to use both
the general rule and the old exclusion ratio (total investment divided by
expected return). The actual excludable amount is reduced proportionately. The
part of the lump sum excludable from gross income bears the same ratio to the
uncovered investment as the annuity payment bears to the original payment [Reg.
§1.72-11(f)].

Example

Taxpayer A pays $20,000 for an annuity contract providing for
payments to him of $100 per month for his life. At the annuity starting
date he has a life expectancy of 20 years. His expected return is
therefore $24,000 and the exclusion ratio is five-sixths. He continues to
receive the original annuity payments for 5 years, receiving a total of $6,000,
and properly excludes a total of $5,000 from his gross income in his income tax
returns for those years. At the beginning of the next year, A agrees with
the insurer to take a reduced annuity of $75 per month and a lump sum payment
of $4,000 in cash. Of the lump sum he receives, he will include
$250 and exclude $3,750 from his gross income for his taxable year of receipt,
determined as follows:

Aggregate of premiums or
other

consideration paid ................................ $20,000

Less amounts received as an annuity

to the extent they were excludable

from A`s income ...................................... 5,000

Remainder of the consideration................. 15,000

Ratio of the reduction in the amount

of the annuity payments to the

original annuity payments ...............25/100 or 1/4

Lump sum received ...................................4,000

Less one-fourth of the remainder of the

consideration (1/4 of $15,000).................... 3,750

Portion of the lump sum includable in

Gross income .............................................250

The lump sum withdrawal amount is treated as an "amount
not received as an annuity," and taxed under the rules of §72(e).

Variable Annuities—"Amounts Received as an Annuity"

Variable annuities differ from fixed payment annuities in
that the exclusion ratio method cannot be used, since it is not possible to
determine the "expected return" as of the annuity starting
date. Accordingly, the investment in the contract is recovered pro-rata,
out of each expected annuity payment, not as a percentage of each payment, but
as a dollar amount computed by dividing the total investment to be recovered by
the total number of annuity payments expected over the life of the
contact. Reg. §1.72-2(b)(3) Thus, for example, in the case of a
variable annuity payable for the life of the annuitant, reference would be made
to the Annuity Table for the life expectancy factor for the annuitant based on
his age nearest the annuity starting date. The total number of expected
payments (monthly, quarterly or annually, etc., as the case may be) could then
be determined, using this factor, and the total number of payments would be
divided into the total investment in the contract to arrive at the
cost-recovery portion of each payment. In the case of a variable annuity
for a fixed period without regard to life expectancy, the same method is
applicable, but the total number of payments would be readily determinable,
without reference to the Annuity Tables.

Variable Annuity Payments Falling Below The Exclusion Amount

Since the actual total of payments received in a given
year will depend upon investment results in the case of a variable annuity, it
is quite possible that poor investment returns could result in payments which
total less than the computed annual exclusion amount. In such cases, the
unrecovered investment for the year (i.e., the excess of the portion of the
investment in the contract assigned to the year in question over the total of
the distributions received for that year) is not permanently lost, but rather,
it may be, in effect, carried forward for recovery in future years if the
taxpayer so elects in a succeeding taxable year in which a payment is received.
This carry forward is accomplished by dividing the unrecovered excess by the
remaining life expectancy of the annuitant as of the beginning of the next
succeeding year, and adding the resulting amount to the previously-computed
exclusion amount applicable to all future years. See Reg. §1.72-4(d)(3).

Example

A has a variable annuity contract for which she paid
$25,000. utilizing the appropriate Annuity Table, it was determined that
her life expectancy was 20 years as of the annuity starting date, and the annual
exclusion amount was, therefore, $1,250. In the fourth year of annuity
payments, the total received was only $450, or $800 less than the annual
exclusion amount. This 4800 shortfall is then divided by A`s remaining
life expectancy, as of the beginning of the following year. Assuming that
A`s remaining life expectancy at this point is 16 years, the $800 recovery
shortfall is divided by 16, and the resulting amount, $50, is added to the
previous exclusion amount ($1,250) increasing the exclusion amount for future
years to $1,300. For an additional, more complex, example see Reg.
§1.72-4(d)(3)(iii).