Owners Withdrawals May Be Classified Assignments

Qualified & Non-Qualified Annuities are Taxed Differently.

Qualified annuities (such as annuities in an employer-sponsored retirement plan or an IRA) are typically purchased with pre-tax money, so withdrawals are fully taxed as ordinary income.

It’s important to understand that purchasing an annuity in an IRA or an employer plan provides no additional tax benefits than those available through the original tax-deferred retirement plan.

Annuities purchased with after-tax money are taxable upon withdrawal, but only the earnings are taxed. Funds inside an annuity contract grow on a tax-deferred basis, so the contract holder owes no taxes on the income and investment gains from an annuity until contract withdrawals begin.

Nonqualified annuities are taxed differently from most investments:

  • ·A nonqualified annuity grows tax-deferred until withdrawals begin or the policy is annuitized.
  • ·A nonqualified annuity does not provide a step-up in cost basis at death, and the deferred earnings will be taxable as ordinary income to a non-spousal beneficiary.
  • ·Spousal continuation of the policy may be available to preserve continued tax-deferred growth.
  • ·An annuity is included in your estate for estate tax purposes.

Nonqualified annuities bought after August 13, 1982, are taxed on a Last In, First Out (LIFO) basis. This means that as you take withdrawals, the accrued interest will be the first money taken out and taxed as ordinary income. After the interest has been paid, the initial investment amount will then be distributed without any further taxes.

Types of Annuities

Annuities are classified in a number of different ways. For federal tax purposes, annuities are classified as either qualified or nonqualified. A qualified annuity is purchased as part of, or in conjunction with, an employer provided retirement plan or an individual retirement arrangement (such as an Individual Retirement Annuity or a Simplified Employee Pension Plan). If certain requirements are satisfied, contributions made to qualified annuities may be wholly or partially deductible from the taxable income of the individual or employer making the contributions.

A nonqualified annuity is not part of an employer provided retirement program and may be purchased by any individual or entity. Contributions to nonqualified annuities are made with after-tax dollars and are not deductible from gross income for income tax purposes.

Annuities are also classified by type of investment and type of payout. Under a fixed annuity, the owner has both the security of a set rate of return and no investment decisions related to the annuity funds. The title “fixed annuity” does not mean that the earnings rate credited will never change; rather, it means that the earnings rate is set periodically by the issuer and then “fixed” until the rate is changed again.

Non-Natural Owners

Tax Treatment:

Contracts owned by “non-natural” persons are subject to annual tax on the inside buildup in the contract.

Exceptions:

  • Held as a trust or other entity as an agent for a natural person
  • Immediate Annuities
  • Acquired by an estate upon the death of the owner

Not taxable to:

  • charitable organizations
  • pension plans
  • Contracts issued on or before 2/28/86

The owner of a variable annuity has the ability to allocate contributions among underlying mutual funds. The rate of return is dependent upon the performance of those investment options, and there is no guarantee that the investment will not decline. The owner has the potential for earning a greater return than on a fixed annuity, but also assumes the risk of investment decisions.

By law, a variable annuity is considered a security, and the contract must be registered with the Securities and Exchange Commission.

Recently, some companies have begun to market an equity indexed annuity. This annuity is something of a hybrid between fixed and variable annuities. Under an equity indexed annuity, the owner’s principal is usually guaranteed and the rate of return is linked to a stock market index, such as the Standard & Poor’s 500.

Annuities are also classified as immediate or deferred. An immediate annuity is one which is purchased with a single premium and requires payments to begin within one year of purchase of the annuity. A deferred annuity does not have any set payment start date.

Who are the parties to an annuity contract?

The three parties to an annuity contract are the owner, the annuitant, and the beneficiary. In many instances, the owner and the annuitant will be the same.

The owner is usually the purchaser of the annuity and has all the rights under the contract, subject to the rights of any irrevocable beneficiary. The owner is subject to income tax on all payments made from the annuity, regardless of who is named as payee. If applicable, the penalty on any premature distributions is based on the owner’s age. If the owner dies while the contract is in the accumulation phase (discussed later), there is a mandatory distribution of the death benefit.

The owner may be a natural or non-natural person. Some examples of non-natural persons are corporations, partnerships, and trusts. Generally, annuity contracts owned by non-natural persons are not treated as annuity contracts for federal income tax purposes and the earnings on such contracts are taxed annually as ordinary income received or accrued by the owner during the taxable year.

As with many other income taxation rules, there are several exceptions to the non-natural owner rule.

For example, an annuity contract will be treated as owned by a natural person if the owner is a trust or other entity which holds the annuity as an agent for a natural person. However, this special exception will not apply in the case of an employer who is the nominal owner of an annuity contract under a nonqualified deferred compensation arrangement for its employees. Immediate annuities are also excepted from the non-natural owner rule.

The owner names the annuitant and the beneficiary of the annuity contract. The annuitant must be a natural person and serves as the measuring life for purposes of determining the amount and duration of any annuity payments made under the contract. The beneficiary receives the death benefit or any remaining annuity payments upon the death of the owner.

Aggregation Rule

All contracts issued by the same company to the same policyholder during any calendar year will be treated as one contract for purposes of computing taxable distributions. 

Exceptions:

  • Annuitized contracts
  • Immediate annuities
  • Distributions required on death of owner
  • Contracts issued prior to 10/21/88
    Note: If a pre-10/21/88 contract is subsequently exchanged or transferred, the new contract becomes subject to aggregation.

Premature Distribution Penalty

10% of taxable amount.

Exceptions:

  • The owner is over age 59½
  • The owner is disabled after contract purchase
  • The owner, not the non-owner annuitant, dies
  • Pre-TEFRA (prior to 8/14/82 contributions) nonqualified money
  • Immediate nonqualified annuity

Substantially equal payments

  • must continue for 5 years or until owner reaches 59½, whichever is later
  • must be computed based on life expectancy
  • Annuitization (for the owner’s life or life expectancy

Note: An exchange from a deferred to an immediate annuity does not qualify as an immediate annuity for the purposes of avoiding tax penalty.

Tax Consequences of Ownership Changes

Types:

  • Addition/deletion of joint owner
  • Transfer to another individual or entity
  • Assignment

Taxation:

  • Earnings are subject to income tax at time of transfer
  • 10% penalty may apply
  • Gift taxes may apply

Exceptions:

  • Transfers between spouses
  • Transfers incident to divorce
  • Transfers between an individual and his/her grantor trust

Mandatory Distribution upon Death of Owner

If Owner dies Prior to Annuitization:

Surviving owner (or beneficiary) must elect one of the following:

  • immediate lump sum
  • complete withdrawal(s) within 5 years of death
  • annuitization (over the life of the new owner) to start within one year of death. If spouse is sole surviving owner (or beneficiary), spouse can also elect to continue contract. If owner is a grantor trust, death of grantor triggers mandatory distribution.

Mandatory distribution applies to all contracts issued after 1/18/85

If Owner Dies After Annuitization:

Payments continue to beneficiary, based on annuitant’s life and type of payment plan chosen

What are the phases of the annuity contract?

There are two distinct phases of the annuity contract: the accumulation phase and the annuitization phase. During the accumulation phase, the owner generally is not taxed on the earnings credited to the cash value of the annuity contract unless a distribution is received. The accumulation phase continues until the annuity contract is terminated or the annuitization phase begins.

The annuitization phase starts when the contract value is applied to an annuity payout option. This phase continues until the last payment is made according to the annuity payout period chosen by the owner (or in some cases, the beneficiary).

How are the distributions taxed during the accumulation phase?

When an annuity contract is fully surrendered during the accumulation phase, the owner must pay income tax on the earnings in the contract. The owner is not taxed on amounts that represent a return of contributions (such as premiums or investment in the contract). Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis.

In order words, withdrawals from an annuity are made earnings first, and the owner is taxed on the payments until all of the earnings have been distributed. There is an exception to the earnings first rule for contributions made to annuity contracts prior to 8/14/82. These contributions are distributed on a first in, first out (FIFO) basis and the owner is not taxed until such contributions are fully recovered.

There is an aggregation rule which requires that all annuity contracts issued by the same company, to the same owner, in the same calendar year must be treated as one annuity contract for purposes of determining the taxable portion of any distributions.

How are distributions taxed during the annuitization phase?

During annuitization, a portion of each annuity payment represents a return of non-taxable investment in the contract and the balance of each payment is considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio. The exclusion ratio for a fixed annuity is the ratio the investment in the contract bears to the expected return under the contract.

The exclusion ratio for a variable annuity is determined by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered using the exclusion ratio, the annuity payments are fully taxable. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner in his last taxable year.

When does the 10% penalty tax apply?

The 10% penalty tax generally applies to the taxable amount of distributions from annuities made before the owner attains age 59½. However, there are exceptions for distributions: (1) made as a result of the owner’s death or disability; (2) made in substantially equal periodic payments over the life or life expectancy of the owner, or joint lives or joint life expectancy of the owner and designated beneficiary; (3) made under an immediate annuity; or (4) attributable to investment in the annuity made prior to 8/14/82.

What are the tax consequences of a transfer of ownership?

If an individual transfers ownership of a nonqualified annuity issued after 4/22/87, without full and adequate consideration, the owner must pay income tax on the earnings in the contract at the time of the transfer (except for transfers to a spouse or transfers made to a former spouse incident to a divorce). If the contract was issued before that date, the earnings in the contract can continue to be deferred, with the old cost basis carried over to the new owner. Transfer of ownership includes the addition or deletion of a joint owner. Also, the transfer of ownership may result in gift tax consequences for the owner.

What about Collateral Assignments?

Individuals who assign their annuities as collateral for loans may be surprised by the treatment of assignments. Generally, any collaterally assigned, pledged, or received as a loan under an annuity issued after 8/13/82 is treated as if it was distributed from the annuity. The amount collaterally assigned is taxed according to the rules applicable to partial withdrawals and full surrenders and may also be subject to the 10% penalty tax. If the entire contract is assigned or pledged, then earnings subsequently credited to the contract are automatically deemed subject to the assignment or pledge and are treated as additional partial withdrawals.

What happens at the owners’ death?

Distributions

If the owner dies after the annuitization phase has begun, the remaining payments, if any, must be paid out at least as rapidly as under the annuity payout option in effect at the time of the owner’s death.

If a beneficiary receives the remaining payments under the annuity payout option in effect at the owner’s death, the taxable and nontaxable portions of such payments will continue to be determined by the original exclusion ratio.

Withdrawals

Pre-TEFRA Contracts (Prior to 8/14/82):

  • Principal out first – Not taxable
  • Earnings outlast – fully taxable, but no penalty tax –

Post TEFRA Contracts (After 8/13/82)

  • Earnings out first – Fully taxable and may be subject to penalty tax
  • Principal out last – Not taxable

Notes:

If a pre-TEFRA contract is subsequently exchanged, it keeps pre-TEFRA tax treatment. Sub-accounts are combined to compute income in the contract

If the owner dies during the accumulation phase, the entire death benefit must be distributed within five years of the date of the owner’s death. However, there is an exception to the five-year rule, if the death benefit is paid as an annuity over the life, or a period not longer than the life expectancy, of the beneficiary and the payments start within one year of the owner’s date of death. If an annuity contract has joint owners, the distribution at death rules are applied upon the first death.

Under a special exception to the distribution at death rules, if the beneficiary is the surviving spouse of the owner, the annuity contract may be continued with the surviving spouse as the owner. If the owner of the annuity is a non-natural owner, then the annuitant’s death triggers the distribution at death rules. In addition, the distribution at death rules are also triggered by a change in the annuitant on an annuity contract owned by a non-natural person. 

Income Tax. Unlike death benefits paid from life insurance policies, the beneficiary may be taxed on distributions made from an annuity after the owner’s death. Amounts paid under the five-year rule are taxed in the same manner as partial withdrawals or full surrenders, and amounts paid under an annuity option are taxed in the same manner as annuity payments.

For variable annuity contracts issued on or after 10/29/79, and for all fixed annuity contracts, there is no “step-up” in basis for income tax purposes and the beneficiary pays income tax on the earnings. However, the beneficiary is entitled to deduct a portion of estate tax paid on the annuity for income tax purposes. For variable annuity contracts issued prior to 10/21/79, there is a “step-up” in basis for income tax purposes and no income tax is payable on the earnings.

Estate Tax

For federal estate tax purposes, the total value of the contract is subject to estate tax. Except as noted above, annuities are income in respect of a decedent and there is no “step-up” in basis for the contract and the annuity is subject to income tax when distributed

Tax-Qualified Annuities

Qualified annuities refers to an annuity that is purchased inside of a qualified retirement plan, like an Individual Retirement Account (IRA). A qualified annuity is taxed identically to any other qualified account such as an IRA, 401(k), profit sharing plan or other tax-deferred retirement account.

You can buy an annuity with funds in your IRA, and if you use pretax money from an IRA or a 401(k) to purchase the annuity, then all payouts will be fully taxed.

The annuity does not gain any additional tax advantages when housed inside of the qualified retirement plan, but will be subject to rules that govern qualified plans.

Annuities are chosen as part of a qualified plan primarily for their ability to provide a guaranteed income to the annuitant at retirement. But you must understand the rules for annuities inside of qualified plans.

Tax-deductible contributions

Annuities inside of a qualified retirement plan can take advantage of tax-deductible contributions, which are normally not an option when contributing money to an annuity. As a trade-off, contribution limits apply to annuities inside of a qualified plan.

Tax-deferred accumulation

Annuities inside of a qualified plan enjoy tax-deferred accumulation of cash values inside the annuity account. This means that money will not be taxed while it is inside of your qualified annuity.

Taxation of withdrawals

Withdrawals from a qualified annuity are taxed at ordinary income tax rates.

Because the contributions were tax-deductible, you “lose” the exclusion ratio normally found in an annuity.

The “exclusion ratio” in non-qualified annuities reduces your income tax burden by allowing you to create an annuity from your savings

When this happens, part of your monthly retirement check is comprised of principal and part of the check is comprised of interest. Since, normally, only interest is taxed, this helps to reduce current income taxes during retirement.

Investing in an annuity contract in the context of a qualified retirement plan moots the tax-deferral benefits of the annuity, since assets in qualified plans are already afforded tax deferral anyway. Still, annuities offer other features that might justify using them within a qualified retirement plan.

“Critics frequently question the value of putting an annuity, which offers tax-deferral benefits, in another tax-deferred investment such as a qualified plan or IRA. However, this argument fails to recognize the great value that annuity insurance guarantees can offer. 

Annuities offer consumers the option of insuring that the pre-tax dollars they have allocated for retirement are protected against downside market risk. They also offer beneficiary protection in the form of a guaranteed minimum death benefit, and the ability to convert retirement savings into a lifetime stream of income-all of which help ensure that their hard-earned savings will be there when they, or their heirs, need them most.”

The preceding is for information purposes only as we do not give tax advise, you should consult your tax professional for complete information regarding annuity taxation.

Sunday, August 1st, 2010Wealth Preservation

A sole proprietor often withdraws money from business profits. Because he likely does not receive a regular paycheck from the business, withdrawing business funds is how he pays himself for the work he performs. However, owner withdrawals are treated differently on the business financial statements than paychecks for employees.

Balance Sheet

A balance sheet is one of the fundamental financial statements used by most businesses. It details the company's financial standing at a particular moment. The balance sheet reports the assets — property and rights to property — belonging to the company, such as equipment and accounts receivable. The balance sheet also shows the liabilities — debts or obligations — owed to others, such as accounts payable and notes payable. Lastly, the balance sheet reports the equity belonging to the company. Equity is the amount remaining after deducting liabilities from assets; this is the amount to which the owner has claim. The balance sheet is governed by the fundamental accounting equation: Assets are always equal to liabilities and equity together.

Owner Capital

"Owner Capital" is reported in the equity section of a sole proprietorship balance sheet. Any money the owner invests to start the business or keep it running is classified as owner capital. Because equity accounts normally have a credit balance, all owner contributions are recorded as credits. Additionally, equipment or supplies donated to the business by the owner should be included in the owner capital account. At the end of the fiscal period, the net income or net loss also is transferred to the owner capital account.

Owner Withdrawals

"Owner Withdrawals," or "Owner Draws," is a contra-equity account. This means that it is reported in the equity section of the balance sheet, but its normal balance is the opposite of a regular equity account. Because a normal equity account has a credit balance, the withdrawal account has a debit balance. For example, if the owner withdraws $1,000 from the company for personal use, a debit of $1,000 is entered to "Owner Withdrawals," and a credit of $1,000 is entered to "Cash." If this is the only withdrawal made by the owner so far during the fiscal year, the balance sheet has a line showing the owner capital and a line showing owner withdrawals of $1,000. Owner withdrawals are subtracted from owner capital to obtain the equity total.

Closing Process

At the end of the business's fiscal period, the draw account gets closed so that it starts the new period with a zero balance. The owner draw amount is transferred into the owner capital account, reflecting that the amount of draws for the fiscal period reduced the amount of capital retained in the business. For example, if at the end of the fiscal period, the balance in the draws account is $5,000, a credit of $5,000 is posted to "Owner Withdrawals," thus leaving an ending balance of zero in that account. The credit of $5,000 is posted to "Owner Capital."

About the Author

Diane Scott started writing professionally in 2009 and has had articles published at Type-A Parent and other websites. She has extensive business and accounting experience. Scott holds a Bachelor of Science in psychology from Brigham Young University.

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