Tax 6-3 & 4 Annuities Flashcards
Annuities
The buyer of an annuity makes one or more investments into the annuity contract in exchange for the promise of annual or more frequent payments for the rest of his or her life or for some other specified period. There is not a _____ annual contribution.
minimum or maximum
(6-3,4, pg 17)
maximum
If the annuity holder dies during the accumulation period, the beneficiary is guaranteed no less than the amount invested.
Annuities
Annuities also vary as to the time of payment. They may begin payment immediately or, in the case of many contracts, payments may be deferred. With a _____ annuity, the annuitant pays now for future fixed or variable annuity payments.
(6-3,4, pg 17)
deferred
The tax treatment is a key component of an investment in an annuity contract.
Annuities
Exclusion Ratio
Even though many annuity contracts are never annuitized, it is important to be able to determine the tax consequences upon annuitization. Annuity payments or periodic payments from a commercial annuity are partially a return of capital and partially interest income. The return of capital is TAXABLE OR NONTAXABLE, whereas the interest is taxable as ordinary income.
(6-3,4, pg 18)
nontaxable
Annuities
Exclusion Ratio
To find the amount excluded in a fixed annuity, it is necessary to determine the exclusion ratio. The exclusion ratio consists of the investment in the annuity contract divided by the total expected return. This ratio is multiplied by the _____ return each year to determine the annual amount that is excluded.
(6-3,4, pg 18)
annual return
To get the total expected return, multiply the annual payments by a life expectancy multiple supplied by the appropriate Treasury table.
Investment in the annuity
÷ Total expected return
= Exclusion Ratio
Annual payments
* Life expectancy
= Annual return
Annuities
Exclusion Ratio
Assume that Andrew purchased an annuity contract for $36,000 that provides for payments of $200 per month, and assume that his life expectancy is 20 years at the time the payments are to begin. The total expected return on the contract is $48,000 ($200 per month × 12 months × 20 years). Thus, Andrew’s exclusion ratio is…
(6-3,4, pg 18)
75%, computed as follows:
$200 Amount of payment
* 12 Months
* 20 Years
= $48,000 Total expected return
$36,000 Investment
/ $48,000 Total expected return
= 75% Exclusion ratio
$200 Payment
- $150 Return of capital (untaxed)
= $50 Taxed as ordinary income
income.
Annuities
Exclusion Ratio
With a variable annuity, the exclusion amount is determined by dividing the investment in the contract by the number of expected payments. For example, assume that Carol purchased a variable annuity for $24,000 and has a life expectancy of 20 years at the time the payments are to begin. Annuity payments are to be made monthly. The number of anticipated payments is…
(6-3,4, pg 18)
240
12 Months
* 20 Years
= 240
Annuities
Exclusion Ratio
For both the fixed and variable annuity calculations, the “investment in the contract” is the net cost of the contract as of the annuity start date. This is the total amount of premiums paid reduced by any distributions that were excluded from income. For example, assume that John had invested $200,000 in a pre-August 14, 1982, annuity contract. In 1999, he took a nonperiodic distribution of $25,000. When the annuity payments began in 2005, the investment in the contract was
(6-3,4, pg 19)
$175,000.
Investment in the annuity
÷ Total expected return
= Exclusion Ratio
Annual payments
* Life expectancy
= Annual return
Annuities
Start Date
The start date refers to the date that the contract is annuitized—when the periodic payments begin under the annuity contract. For annuity contracts that annuitized prior to 1987, the exclusion ratio generally is applied to all future payments, even if the annuitant outlives his or her life expectancy. However, for annuities that started after 1986, the entire annuity payment is _____ once the investment in the contract has been recovered.
partially taxable
taxable
not taxable
(6-3,4, pg 17)
taxable
Annuities
Partial Annuitization
For tax years beginning after 2010, partial annuitization of an annuity contract is allowed. If any amount is received as an annuity for a period of _ _ years or more, or over one or more lives, under any portion of an annuity (endowment or life insurance) contract, that portion of the annuity will be treated as a separate
contract for annuity taxation purposes.
10
15
20
(6-3,4, pg 19)
10
Thus, holders of non-qualified (commercial) annuities can elect to receive a portion of an annuity contract in the form of a stream of annuity payments, leaving the remainder of the contract to accumulate income on a tax-deferred basis.
Note: This provision does not apply to qualified annuities, such as might be received from a retirement plan (Senate Finance Committee’s Summary, July 21, 2010).
Annuities
Non-periodic Distribution (lump-sum)
Distribution prior to the annuity start date. The individual who holds a contract issued before August 14, 1982, retains the right of tax-free early withdrawal of
his or her investment. In other words, the non-periodic payment is treated on a first-in, first-out (FIFO) basis. For example, assume that a taxpayer purchased a
deferred annuity in 1981 for $50,000, and that the cash surrender value is now $180,000. The contract has not reached its start date. A non-periodic distribution of up to $_ _, _ _ _ would be tax free, as the taxpayer is withdrawing his or her investment first.
$25,000
$50,000
$75,000
(6-3,4, pg 20)
$50,000
Annuities
Non-periodic Distribution (lump-sum)
Non-periodic withdrawals from an annuity contract issued after August 13, 1982, are treated on a LIFO or FIFO basis.
(6-3,4, pg 20)
LIFO
In other words, the withdrawals consist of, first, fully taxable interest, and second, tax-free principal to the extent that interest payments are fully exhausted. This rule applies to the extent that the cash surrender value of the contract exceeds the investment in the contract.
Annuities
Non-periodic Distribution (lump-sum)
Non-periodic distribution after the annuity start date. A non-periodic payment from an annuity contract received on or after the annuity start date is generally fully taxable to the extent that the withdrawal exceeds the _____ remaining in the contract.
(6-3,4, pg 20)
investment (cost)
Annuities
An ____ policy is a life insurance contract designed to pay a lump sum after a specific term (on its ‘maturity’) or on death. Typical maturities are ten, fifteen or twenty years up to a certain age limit. Some policies also pay out in the case of critical illness.
(LO 6-3,4)
endowment
Annuities
Module Check
- Which one of the following does not correctly state a characteristic of a commercial annuity?
- With an annuity, there is a maximum annual contribution per year, which is adjusted yearly for inflation.
- An annuity is a contract in which investments are made in exchange for a promise of regular frequent payments for the rest of a taxpayer’s life or a fixed period of time.
- Annuity contracts may vary regarding the payment time period and the frequency of the payments.
- An annuity payment is generally part return of capital and part interest payment.
(LO 6-3,4)
- With an annuity, there is a maximum annual contribution per year, which is adjusted yearly for inflation.
There is no set maximum annual contribution that may be made to a commercial annuity.
An annuity is a contract in which a taxpayer makes an investment in exchange for future or current periodic payments.
The parties to an annuity contract are free to negotiate any terms that are satisfactory to both parties.
Each annuity payment is subject to an exclusion ratio in which a portion of each payment is a return of capital and a portion is an interest payment.
Annuities
Module Check
- Which one of the following statements is true regarding nonperiodic distributions from an annuity contract prior to the annuity start date, issued after August 13, 1982?
- A nonperiodic distribution is first considered a tax-free return of principal and then a taxable interest payment.
- A nonperiodic distribution is prorated equally between a tax-free return of principal and a taxable interest payment.
- A nonperiodic distribution is taxed under the exclusion ratio rules.
- A nonperiodic distribution is taxed first as a taxable interest payment until the interest payments are completely exhausted and then as a tax-free return of principal.
(LO 6-4)
- A nonperiodic distribution is taxed first as a taxable interest payment until the interest payments are completely exhausted and then as a tax-free return of principal.
A nonperiodic distribution from an annuity issued after August 13, 1982, is treated first as a taxable interest payment and then as a tax-free return of principal (LIFO).
A nonperiodic distribution is not taxed under the exclusion ratio rules.
