Any investment income earned on annuities during the accumulation period is not taxable until distributed to the policyholder with one major exception.
If an annuity contract is held by an entity who is not a natural person (corporation or trust), the annuity taxation rules differ. The income on the contract must be treated as ordinary income received or accrued by the policyholder that year. Annuity benefit payments are a combination of principal and interest. Each payment is considered a partial return of basis and partially taxable income using an inclusion/exclusion ratio
a. Exclusion ratio - The numerator for the exclusion ratio is the cost basis in the annuity. The denominator is the total expected benefits.
b. Inclusion ratio - The numerator for the inclusion ratio is the total expected benefit less the cost basis. The denominator is the total expected benefits.
Example: John retired on December 31, 2004, and receives a monthly annuity pension benefit of $1,000 payable for life. His life expectancy at the date of retirement is 10 years. During his years of employment, John contributed $30,000 to the cost of his company's pension plan.
Solution: Excluded from John's taxable income in 2005 is $3,000 ($30,000 ÷ $120,000 = .25 or 25% 2005 (12 payments x $1,000) x ¼ = $3,000.
Tom purchased a single premium immediate annuity for $100,000 lump sum for his life. Tom will receive a 4% return on his investment for the life of the contract. The insurance company has guaranteed Tom a monthly payment of $1,200 for the rest of his life. According to actuarial tables, Tom is expected to live another 10 years (120 payments). Which of the following is correct?
A. If Tom dies after receiving only $75,000 back, his beneficiary will not be taxed on the $25,000 return of premium.
B. If Tom lives longer than 10 years, all amounts received after the 120th payment must be included in his gross income.
C. If Tom collects $12,000 in his first calendar year from the annuity, the full payment will be considered a return of principal and not taxable income to Tom.
D. Tom's first monthly payment for $1,200 will have an exclusion ratio of 96%.
When Tom purchases a single-life immediate annuity, the insurance company will guarantee payments for Tom's life only, so payments will cease at his death. Tom's exclusion ratio will be 69.44% ($100,000 divided by $144,000), so a payment for $1,200 will have $833.33 excluded from gross income. If Tom lives longer than his 120th payment, all future payments will be includable as gross income. The 4% return is irrelevant for this question.
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