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 December 31, 1986

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 December 31, 1986

If the annuity starting date is after December 31, 1986, the exclusion is limited to the investment in the contract [I.R.C. §72(b)(2)]. This means that the exclusion ratio will apply only until the total amount excluded equals the investment in the contract. After that, the full amount of each annuity payment is included in gross income. If the annuitant dies before recovering the investment in the contract, the unrecovered investment is deductible on the annuitant`s last income tax return.

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 July 1, 1986, and the annuity starting date was before July 1, 1986, the gender-based tables are used. The annuitant has the option of computing a new exclusion ratio using the unisex tables but that will rarely be advantageous.

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 July 1, 1986, and after June 30, 1986, and the contract provides for a disqualifying form of payment, the unisex tables must be used.

6.      6.      If all investments in the contract were made after June 30, 1986, the unisex tables must be used.

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 June 30, 1986, regardless of when the investments in the contract were made.

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 June 30, 1986, he can use the gender-based tables. According to Table I, his life expectancy is 17.5 years. To find the portion of his annuity payment that is exempt from tax, he divides the investment ($55,680) by the expected return ($4,000 x 17.5, or $70,000). This quotient (.795 carried to three decimal places) is his exclusion ratio. He multiplies the exclusion ratio (.795) by the annual annuity payments ($4,000) to find the amount of each payment that is exempt from tax ($3,180). The balance of each year`s payments ($820) is taxable income.

Assume that the same man has a brother two years younger who bought an identical annuity at age 61 after June 30, 1986. The younger brother must use the unisex tables to calculate his exclusion ratio. According to Table V, his life expectancy is 23.3 years. His exclusion ratio equals the investment in the contract ($55,680) divided by the expected return ($4,000 x 23.3, or $93,200), which equals .597. The amount of each payment exempt from tax equals the exclusion ratio (.597) multiplied by the annual payments ($4,000), which is $2,388. The balance of the payment received each year ($1,612) is taxable income.

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 December 31,1986

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 December 31, 1986

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 June 30, 1986) and VIII (unisex for all other contracts) are used for this purpose.  A factor is located in the table based upon the annuitant`s age and the stated maximum duration of the annuity period.  This factor is multiplied times the total of the periodic payments to be received in a year`s period, and the result is the expected return under the temporary life annuity.

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 January 1, 1954, the survivor proceeds as with a similar level-payment joint and survivor annuity.

For both types, if neither annuitant died before January 1, 1954, the taxpayer divides total investment in the contract by expected return, and multiplies this quotient by the annual payment received. Investment in the contract is computed in accordance with the general rule. Expected return, however, presents a special problem.

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 July 1,1986. The Table II and Table IIA factors are 24.6 and 21.1, respectively. Then 24.6 - 12.1 = 12.5, and 12.5 x $1,200 = $15,000. Since 12.1 x $1,800 = $21,780, and $15,000 + $21,780 = $36,780, the exclusion ratio is $30,000/$36,780, or .816. Accordingly, while both annuitants live, 81.6 percent of the $1,800 they receive each year, or $1,468.80 a year, will be tax-exempt. Of the widow`s or widower`s $1,200 a year, $979.20 will be tax-exempt.

If the couple in the above example bought an identical annuity after June 30, 1986, the calculations would be the same except that the return multiples would be taken from Tables VI and VIA.

If one annuitant has died since January 1, 1954, the survivor may have a right to an annual deduction from gross income for estate tax paid attributable to the annuity. This deduction is computed as for a level-payment annuity. The annual payment used in this computation is the one the survivor receives.

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).