1. Have a business entity own a deferred annuity
Non-natural owners of deferred annuities purchased after February 28, 1986, lose the income tax deferral and instead will be subject to income tax each year on the growth. This rule applies to family limited partnerships and corporations, but not to trusts that hold annuities as an agent for a single, clearly definable beneficiary who is a natural person. IRC §72(u).
2. Gift an annuity to someone when there is gain in the contract
For annuity contracts issued before April 23, 1987, the donor must report the gain in the contract in the year the contract is eventually surrendered by the donee. The balance of the gain that grew from the time of the gift to the time of the surrender is taxed to the donee. For annuity contracts issued after April 22, 1987, the donor must report the gain in the contract at the time of the gift and the value of the contract may be subject to federal gift tax. This rule doesn’t apply for transfers between spouses or former spouses. IRC §72(e)
3. Have joint owners on an annuity who are not spouses
When the first owner dies, assuming they aren’t the annuitant, the deemed distribution rules of IRC §72(s) come into play. If one joint owner dies (and the joint owners are not spouses), the surviving owner has one year to “annuitize” the annuity over their own life or five years to take the entire distribution (from the date of the first joint owner’s death).
The rules are different if the joint owners are spouses. When the first of the two spousal joint owners dies, the remaining spouse may continue on as the sole owner of the contract and no deemed distribution occurs, IRC §72(s). It is worth noting, however, that if the remaining spouse stays on the contract as sole owner, the value of the contract is not considered death benefit at the time of the first owner’s death and all the penalties apply as if the contract was solely owned by the surviving spouse from the start.
4. Violate the “Goodman rule” when the owner isn’t the annuitant or beneficiary
For example, if a husband owns an annuity with his wife as the annuitant and his son as the beneficiary, what happens when the wife dies? If she dies first, the death benefit is paid to the beneficiary, the son. The transaction is considered a taxable gift from the still-living father to his son. The father must apply his unified credit or, if it’s exhausted from previous gifting, pay gift tax on the death proceeds to the son. The son pays income tax on the portion of the death proceeds that exceeds the cost basis.
5. Not name a contingent beneficiary
What happens if your beneficiary predeceases the annuitant? If no contingent beneficiary has been named, most annuity contracts will require the death benefit to be paid to the owner or owner’s estate at the annuitant’s death. As a rule of thumb, always name a contingent beneficiary and keep beneficiary designations up to date for all your annuity and life sales.
6. Borrow against the annuity
After August 13, 1982, any amount borrowed from an annuity, to the extent there is gain, is considered taxable income. The 10 percent penalty tax typically under IRC §72(t) applies if the owner is under age 59½. Basically, don’t borrow against an annuity. Not all annuities allow loans, but this provision equally applies to using the annuity as collateral for a loan or assigned to cover a loan.
7. Have a collateral assignment on an annuity
A collateral assignment against a deferred annuity is considered a distribution of “an amount not received as an annuity.” The amount of the collateral assignment will be considered taxable income to the annuity owner to the extent of gain in the annuity contract. For example, if an annuity is collaterally assigned on a $100,000 loan and the annuity has $65,000 in gain, the amount of taxable income is $65,000. Additionally, if the owner is under age 59½, the 10 percent penalty tax provisions also apply.
8. Annuitize a deferred annuity before age 59½ that isn’t over the owner’s life or life expectancy
For example, your client is age 42 and has had a deferred annuity contract for 14 years. The surrender charges are long over and your client wants to look at an immediate annuity or some type of income feature. If he “annuitizes” over his life or life expectancy, he avoids the 10 percent penalty tax for pre-59½ distributions. If he annuitizes over a 10-year fixed period, the 10 percent penalty tax applies. Why doesn’t the immediate annuity exception apply to the 10-year fixed period option that overrides the 10 percent penalty tax? The new immediate annuity refers back to the original date of the deferred annuity. The “annuitization” must occur within one year of the deferred annuity issue date in order for it to qualify as an immediate annuity (Revenue Ruling 92-95).