Due to old and unmodified IRS life expectancy tables, particularly table V and VIII, many immediate annuities (mortality polled income contracts) may produce income tax advantages in the form of a “non-taxable” income source. Of course, non-taxable income is not the same as tax free income. How is this possible? It’s possible because these old IRS tables still assume shorter life expectancies derived from 1970s and earlier data. The shorter the assumed life expectancy for IRS tax issues the greater the premium cost recovery rate as a percentage of the annual annuity income.
When these old IRS tables are combined with the current annuity industry practice of assuming modern life expectancies and the ultra-low interest rate environment, the actual annuity annual income can be completely non-taxable depending on the immediate annuity variability selected. Just because these contracts may initially produce 100% non-taxable income doesn’t mean they are not earning any interest. You always earn interest with a fixed annuity but, you just may not have to pay income tax on it right away depending on the contract. Again, we are talking about mortality pooled annuities and not deferred cash value annuities with guaranteed lifetime withdrawal benefit (GLWB) features.
Let’s look at a few examples of how this works utilizing an easy to understand annuity and easy to calculate cost basis recovery rate. One of the easiest immediate contracts to understand, not necessarily the most popular, is the “life-only” annuity contract. Simply put, this contract pays an annual income for the lifetime of an individual then, terminates upon his or her death. In this case, the IRS uses Table V (without respect to gender) to calculate the annual annuity premium cost recovery permitted.
For a life-only annuity, a person age 76 gets 11.90 years or 142.80 months to calculate the annual premium cost recovery permitted for income tax purposes. If the premium cost basis is $100,000 this amounts to a monthly premium cost recovery rate of $700.00. However, if the actually monthly annuity payment from the company is only $695, guess what? None of the annuity income is taxable until the entire premium cost has been recovered. How long will this take? If the cost basis is $100,000 and the monthly annuity payment rate is $695 the premium cost recovery duration is 143.88 months ($100,000/$695) or about 12 years. This effectively gives this person a “first-in-first out” or “FIFO” annuity income tax treatment for 12 years. The immediate annuity internal deferral of the taxable gains won’t come into play until after this time when, the entire annuity income becomes taxable. Generally for cash payment purchase transactions, annuity FIFO taxation and utilization of an internal taxable income deferral hasn’t been available for annuity premiums paid after August 13, 1982.
Regarding this contract variability and under current annuity pricing, generally this type of tax treatment is possible for males age 76 and females age 72 and over. Females start younger because the life insurance companies estimate longer female life expectancies vs. their male counter parts and therefore reduce female annual annuity incomes accordingly. However, both genders are compelled to use the same IRS table V numbers.
Let’s consider temporary life annuities. A temporary life annuity is also a life contingent annuity but the payments are limited to a set number of years. For example, a 10-year (120 months) contract will produce annual income until death or the completion of 10-years whichever occurs first. While, there are a multitude of uses for temporary life annuities, we are only addressing the income tax issues here. Many individuals just assume the annuity premium cost recovery is spread over the 10-year payment duration. However, this is not the case! In this example, the IRS uses Table VIII. For a person age 80, this table calls for a premium cost recovery rate of 7.50 years (90 months).
This means individuals, in this example age 80, get to cram all the tax basis recovery into the first 7.50 contract years even though they have a 10-year payment contract. Of course, the shorter the cost basis recovery period, the greater the annual recovery rate vs the actual annuity annual income payment.
When doing income tax and income planning for your clients in 2015 don’t forget these very tax efficient and guaranteed contracts. Given where we are regarding current annuity pricing and the old IRS rules and tables, you can really generate rich non-taxable income sources. That’s the idea. Always Keep Your Hands Up.