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Author: BaumgrenzeJohn One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121061  
Subject: Term Certain Annuitization - Inherited Annuity Date: 9/20/2012 12:42 PM
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I am confused about the tax treatment of a non-qualified annuity that is being inherited by a less than 59-1/2 year old beneficiary. The annuity is ~63% taxable.

It is probably not significant, but there was one surrender withdrawn by the purchaser during the lifetime of the annuity. I include this because there are tax consequences resulting from pay-outs from the annuity.

The beneficiary is considering a 5 year, term certain payout as an alternative to a lump-sum payment and trying to understand the income tax consequences. An illustration provided by the issuer of the annuity says that 63% of each payment is subject to income taxes. This suggests that the LIFO rule does not apply in this case and the tax consequences are relatively straight forward. Is this correct? Does the age of the beneficiary impact the tax status of a term certain payout?

I am a family member overseeing payout applications for 4 beneficiaries. Does anyone know if California, Illinois, Vermont, and/or Virginia treat the payout differently than the IRS?

Thank you,

baumgrenze
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Author: inparadise Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116639 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/20/2012 4:52 PM
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The beneficiary is considering a 5 year, term certain payout as an alternative to a lump-sum payment and trying to understand the income tax consequences. An illustration provided by the issuer of the annuity says that 63% of each payment is subject to income taxes. This suggests that the LIFO rule does not apply in this case and the tax consequences are relatively straight forward. Is this correct? Does the age of the beneficiary impact the tax status of a term certain payout?

I could very well be wrong about what I am going to say, so treat it as a starting point for research if the possibility is interesting. When Dad died I inherited all sorts of accounts, one of which was an annuity that was partially tax deferred. I was, IIRC, able to roll over the tax deferred portion into an inherited IRA. It was a confusing time, and I basically just sent the paperwork to my financial planner to deal with and decode, but I could swear that I took the funds that were not tax deferred and rolled the tax deferred funds into the inherited IRA.

Sorry to be so uncertain. It really wasn't the best time for clear thinking.

IP

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Author: ptheland Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116640 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/20/2012 6:09 PM
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Does anyone know if California, Illinois, Vermont, and/or Virginia treat the payout differently than the IRS?

I'm sure that CA treats annuities the same as the IRS.

--Peter

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Author: BaumgrenzeJohn One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116642 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/20/2012 10:56 PM
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Thank you IP and Peter,

I tried a bit more web based research. The answers I found did not satisfy me.

I'd like confirmation that when an annuity is annuitized, by the owner or a beneficiary, is not subject to LIFO rules; that each payment is equally part capital and part earnings in the same ratio as the investment, and that the earnings portion is taxable as ordinary income.

Thanks in advance,

baumgrenze

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Author: TMFPMarti Big funky green star, 20000 posts Home Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116645 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/20/2012 11:09 PM
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I'd like confirmation that when an annuity is annuitized, by the owner or a beneficiary, is not subject to LIFO rules; that each payment is equally part capital and part earnings in the same ratio as the investment, and that the earnings portion is taxable as ordinary income.

Have you checked Pub 575?

Phil
Rule Your Retirement Home Fool

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Author: BaumgrenzeJohn One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116646 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/20/2012 11:58 PM
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Thank you Phil,

No, my searching sent me to Pub 939 which made no sense to me. On quick reading, it seems only to apply to life annuitizations, (based on the examples) not term-certain ones elected by beneficiaries.

I've downloaded Pub 575 and it says that the General Rule (393) must be used for nonqualified annuities. Catch 22, or so it seems to me.

I am asking about a beneficiary annuitizing a share of two sizeable annuities, both non-qualified, both started (the investment was made) before 11/18/96. On average they are 63% taxable and 37% invested capital. The payout is envisioned as a 5 year term-certain. I think that is an approach that makes sense for a beneficiary who wants to spread the taxes over more than one year and to leave any residue to a beneficiary. (A 10 year payout is also offered.) The term-certain illustrations (subject to change on application) project an average of ~0.3%/year, so they are 'better than money in the bank.'

I'm not privy to the tax status of the beneficiaries, two are retired and over 70.5 and two are 40ish and still earning. This exercise does not impact my income/taxes; I'm just trying to be a good brother and father.

I'd appreciate any insights you can offer.

Thanks again for your patience.

baumgrenze

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Author: ptheland Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116647 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/21/2012 12:25 AM
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I'd like confirmation that when an annuity is annuitized, by the owner or a beneficiary, is not subject to LIFO rules; that each payment is equally part capital and part earnings in the same ratio as the investment, and that the earnings portion is taxable as ordinary income.

I've never fully understood how the insurance company determines what part of an annuity payment is taxable and what is return of the investment. All I do know is that that is the case. Every payment is split.

There are some situations when the principal is recovered fast enough (three years, I think) and some other requirement are met (which I don't recall), then you just recover your principal first and then every payment after that is taxable income. But I've only read about it, I've never actually run into it in practice.

--Peter

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Author: BaumgrenzeJohn One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116648 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/21/2012 1:27 AM
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Peter,

Could it be that you are referring to what is discussed here:

http://www.annuityadvisors.com/FAQ/General.aspx

Start with the section entitled: "Taxation of Annuity Income," and read down through the end of "Taxation of Annuity Withdrawals and Distributions."

It reads:

"For annuities purchased before August 14, 1982, the general rule regarding cash withdrawals, amounts received as loans or amounts received on surrenders is that they are tax free until they equal the contract owner’s basis or investment in the contract. After that, they are fully taxable as income. These annuities are given “first-in, first-out” (FIFO) treatment.

Annuities purchased on or after August 14, 1982, the general rule regarding these same kinds of distributions is that they will be treated first as fully taxable interest payments and only second as a recovery of non-taxable basis. These annuities are given “last-in, first-out” (LIFO) treatment."

On this page:

http://www.annuityadvisors.com/RefCenterDetail.aspx?guid=b00...

it is called "1982 – TEFRA."

Thanks for persisting.

baumgrenze

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Author: Wradical Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116650 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/21/2012 10:15 AM
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If you look closer at the quoted material is correct as it pertains to
"amounts received as loans or amounts received on surrenders "

http://www.annuityadvisors.com/FAQ/General.aspx

"Taxation of Annuity Withdrawals and Distributions."

"For annuities purchased before August 14, 1982, the general rule regarding cash withdrawals, amounts received as loans or amounts received on surrenders is that they are tax free until they equal the contract owner’s basis or investment in the contract. After that, they are fully taxable as income. These annuities are given “first-in, first-out” (FIFO) treatment.

Annuities purchased on or after August 14, 1982, the general rule regarding these same kinds of distributions is that they will be treated first as fully taxable interest payments and only second as a recovery of non-taxable basis. These annuities are given “last-in, first-out” (LIFO) treatment."


However, these only pertain to the transactions described, for tax-deferred annuities, and not a "pure, actual" stream of payments, which is what annuities were origianlly designed to be, and what I understand the OPs questions are about. These are described in the first paragraph,

Taxation of Annuity Income
Income received from a nonqualified annuity under a structured annuitization option is taxed in accordance with the exclusion ratio. The exclusion ratio treats each annuity payment as part principal and part interest, thereby excluding a portion of each payment from tax and taxing a portion. The exclusion ratio is the “investment in the contract” (i.e., total premiums paid) divided by the “expected return” (i.e., total amounts to be received). If the expected return is not based on a life expectancy – as would be the case with a fixed term of years option, for example – it is calculated simply by adding the total amounts to be received. If the expected return is based on a life (or joint life) expectancy, certain IRS-prescribed tables and multipliers are used to determine the total expected return.


By the way, that other rule about the 3-yr. payback, where you get the cost up front, and then all income after that, you used to see that most commonly with US Government retirees. Today, it's pretty rare. Govt. retirees are mostly taxed on the regular exclusion-percentage basis, like others.

Also, the OP should be sure about the meaning of the phrase "term certain", when discussing annuities. Are we talking about an actual fixed term, or a guaranteed minimum term equivalent in the case of death? You sometimes see something written, "lifetime joint & several annuity, with 10-yr. term certain". That means if they die prematurely, the annuity will pay off at least 10 yrs. worth of payments as a death payout. The phrase gets used loosely sometimes.

Bill

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Author: vkg Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116651 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/21/2012 10:23 AM
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Annunities are complicated and varied products. If the agent can't answer your questions, the insurance company should have a division that handles inherited products. Ask the agent for the contact information.

I went to Fidelity, and asked their representative what Fidelity required regarding an estate issue. I remember the look of panic on his face. He gave me the phone number for division handling inheritad assets. The answers weren't what I wanted, but they were able to immediately and competently answer my questions.

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Author: Wradical Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116652 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/21/2012 10:30 AM
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I went to Fidelity, and asked their representative what Fidelity required regarding an estate issue. I remember the look of panic on his face. He gave me the phone number for division handling inheritad assets. The answers weren't what I wanted, but they were able to immediately and competently answer my questions.
===================================
If anything, Schwab is worse. Their local office people can't do anything either. Any transfers from an estate account have to be cleared through their office in Orlando. (I SWEAR I was talking to people wearing Mickey Mouse ears, at all times.)

It's times like that, when a full-service broker seems more capable of doing things, but the commissions they charge lose their attactiveness most days, unfortunately.

Bill

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Author: BaumgrenzeJohn One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116653 of 121061
Subject: Re: Term Certain Annuitization - Inherited Annui Date: 9/21/2012 3:52 PM
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Bill,

Thank you for your patient teasing out of the text I needed to see. Thank you, too, for the pointed questions.

I think this is pretty straightforward:

Single Term Certain Annuity for 5 Years
Provides annuitant an income for 5 years. If death occurs before payments have been made for 5 years, payments continue to the beneficiary at the same income amount for the balance of the 5 year guarantee period.

It takes a bit of 'reading between the lines' but I believe that electing annuitization involves a Section 1035 exchange. This implies that any other provider of a comparable annuity is a candidate to provide for the annuitization, but that the beneficiaries need to be alert to the financial soundness of the underlying insurer and the attentiveness of their state insurance department. In any case, they need to ask questions about commissions, etc. involved with the exchange.

My, this has been quite an education. Thanks again for everyone's participation.

baumgrenze

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