Taxation of Annuities Caterpillar

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It is important for Caterpillar employees to understand the nature of annuities and make sound financial planning to maximize tax-deferred growth while avoiding the risks of early withdrawals and surrender charges, says Paul Bergeron, representing the Retirement Group, a division of Wealth Enhancement Group.

'Understanding the tax implications of annuities helps Caterpillar employees plan for Retirement while mitigating tax impacts and maximizing tax deferral,' says Wesley Boudreaux, of the retirement Group, a division of Wealth Enhancement Group.

In this article, we will discuss:

1. How premiums are treated on annuities for Caterpillar employees - including non-deductibility and tax deferral of earnings - is discussed here.

2. Taxation of annuity earnings and distributions including how earnings grow, tax on withdrawals and early withdrawal and complete surrender rules.

3. Including special considerations for gifting and estate planning with annuities - tax consequences, types of transfers & impact on estate and gift taxes.

Income Taxation of Annuities

Income Taxation of Premiums

Your premiums into an annuity as a Caterpillar employee - in one lump sum payment or monthly installments over many years - are usually nondeductible. And you will get no current income tax savings by investing in an annuity, either. But earnings on the annuity's funds will be tax deferred.

Caution:

Most annuity contracts contain limitations, exclusions, fees and charges including mortality and expense charges, account fees, investment management fees, administrative fees, charges for optional benefits, holding periods, termination provisions and terms for keeping the annuity in force. Most annuities charge surrender charges when the contract owner surrenders the annuity. Withdrawals of annuity earnings are taxed as ordinary income and may be subject to surrender charges plus a 10% federal income tax penalty if made before age 59 1/2.

Withdrawals decrease the benefits and values of annuity contracts. Such guarantees depend on the ability of the claims-paying company and on its financial strength. The FDIC or any other government agency does not guarantee annuities; [They are not deposits of, nor guaranteed or endorsed by, any bank or savings association.] For variable annuities the investment return and principal value of an investment option are not guaranteed. Variable annuity subaccounts change with market conditions and the principal may be worth more or less than the original amount invested when the annuity is surrendered.

Taxation of Earnings on Funds Within the Annuity (Cash Value Buildup)

In general, earnings from an annuity grow tax-deferred and the annuity owner pays no income tax on the earnings until they are withdrawn. Remember this as a Caterpillar employee when planning your finances and considering withdrawals.

Caution:

Early withdrawals from an annuity before age 59 1/2 are taxed and may carry a federal 10 percent penalty.

Dividends from an Annuity Are Taxed as Income.

Distributions classifying them as compensation (partial surrenders, full surrenders and annuitization payments) are taxed as ordinary income. For Caterpillar employees, the income tax treatment of distributions from an annuity contract depends on the distribution method selected and the date the annuity contract was established.

Paragraph 179 of the Income Tax Act, 1961:

Income Taxation of Partial Surrenders.

For any Caterpillar employee who signed an annuity contract after August 13, 1982, interest-first rule applies to any partial surrender of the annuity. The interest-first rule holds that the partial surrender must come from the earnings component of the annuity first and not from the principal (until all earnings are withdrawn). The partially surrendered gain therefore constitutes part of the annuitant's gross income and is taxable.

If you bought an annuity contract before August 14, 1982, a partial surrender is generally subject to taxation under the cost-recovery rule. The cost-recovery rule applies to partial surrender first from the investment in the contract (until the entire investment in the contract is depleted). Any remaining part of the partial surrender is treated as contract earnings and taxed as ordinary income.

Taxation of Complete Surrenders.

If you're a Caterpillar employee and annuity holder, know that untaxed earnings (the difference between the cash surrender value of the contract and the net investment in the contract) are subject to income tax if an annuity is fully surrendered.

Example(s):

Mister Smith has a USD 80,000 cash surrender value annuity and has paid premiums of USD 30,000 into the annuity. Once he completely surrenders the annuity, Mr. Smith will pay income tax on USD 50,000 (USD 80,000 - USD 30,000).

Loss on an Annuity Contract.

Annuity recipients who sell or surrender a variable annuity for less than its cost basis may lose money. This may happen if the market falls and the investment loses value.

Example(s):

Mister Smith has a USD 80,000 cash surrender value annuity and has paid premiums of USD 100,000 into the annuity. In exchange for USD 20,000 Mr. Smith gives up the annuity completely.

Tip:

A loss on a variable annuity is a normal loss under Rev. Rul. It is not an investment loss reported on Schedule D 61-201, 1961-2 C.B. 46. Another option is to write off the loss as a miscellaneous itemized deduction subject to the 2 percent floor on Schedule a. Consult a tax expert. Any surrender charges incurred are not part of the loss.

Tip:

In the case of a life only annuity with a starting annuitization date after July 1, 1986, a deduction is allowed for the unrecovered investment in the contract if the sum of all payments received is less than or equal to the investment in the contract.

Caution:

Variable annuities are long-term investments suitable for retirement funding but subject to market fluctuations and investment risk including loss of principal. Variable annuities are sold with a prospectus that outlines the variable annuity, including fees and charges imposed by the product. Such charges include but are not limited to mortality and expense risk charges, administrative fees and charges for optional benefits and riders. The prospectus may be obtained from the insurance company issuing the variable annuity or from your financial professional. Read it carefully before you invest. Annuity Taxation - a Guide to the Rules.

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Annuity payments are taxed differently for a Caterpillar employee and potential annuity holder. In the tax code, two parts of annuity payments are tax deductible: A nontaxable portion of the return of premiums paid into the annuity and a taxable portion of earnings on the annuity. So only a portion - the annuity premiums - is excluded from the annuity owner's aggregate income. The excludable part of every annuity payment equals the annual number of payments multiplied by an exclusion ratio. The fixed annuity exclusion ratio is the sum of the contract investment of the annuity holder at the annuitization start date divided by expected return.

Example(s):

A fixed annuity contract for Mr. Smith pays him USD 200 a month for 20 years. He expects USD 200 / month x 20 years x 12 months / year = USD 48,000. Mr Smith has USD 24,000 invested in the contract and his exclusion ratio is USD 24,000/USD 48,000 = 50 percent. That would leave 50 percent of each USD 200 payment (USD 100) out of Mr. Smith's gross income. The rest of his payment of USD 100 is ordinary income.

Caution:

For variable annuities the rules are different. Variable annuity payments change value so the expected return at the beginning of the annuity can not be estimated. The excludable portion is normally equal to the investment in the contract multiplied by the number of years the annuity is expected to be paid. That calculation varies with annuitization.

Tip:

All deferred annuity contracts that the same insurance company issues to the same policyholder in any calendar year are one annuity contract.

Section 1035 Exchanges & Partial Exchanges.

As a Caterpillar employee and annuity holder, you generally can swap an annuity for another without recognizing an immediate gain or loss under IRC Section 1035. The exchange can be a full swap of one policy for another or a partial swap whereby a portion of funds are directly transferred from an existing annuity contract to a new annuity contract. To qualify for such favorable tax treatment, however, the exchange must satisfy Section 1035.

Caution:

The rules for 1035 exchanges are complicated - and you could pay surrender charges on your 'old' annuity. You may also be charged new sales and surrender fees for the new policy.

How to Gift an Annuity - Income Taxes.

Annuity owners can gift an annuity in two ways:

Holder of annuity can surrender the annuity and transfer the money to the individual. But the annuity owner will pay income tax on the untaxed proceeds (the contract's cash surrender value minus the net investment in the contract). By surrendering the annuity and donating the cash the recipient also is no longer able to earn tax-deferred interest on the annuity. With an income tax and a limited ability to accumulate tax-deferred interest, Caterpillar employees considering gifting an annuity might want to consider other options besides surrender.

The annuity proprietor can pass the annuity contract ownership to the individual. That annuity contract will continue to exist after the transfer, and the person receiving the annuity is the new owner. Yet this method of gifting an annuity usually has immediate tax consequences for the transferor. If the transfer involves an annuity contract issued after April 22, 1987, the transferor is considered to have received income equal to the difference between the contract's cash surrender value at the time of the gift and his or her net investment in the contract. For a Caterpillar employee, this information might be useful in weighing annuity transfer options.

Example(s):

Mr. Smith wants to gift an annuity to his daughter Alexandra. Mr Smith bought the annuity contract after April 22, 1987. He has put USD 12,000 in premiums into the annuity, which has a cash surrender value of USD 20,000. Mr. Smith will recognize USD 8,000 taxable income when he gives the annuity to his daughter. The tax consequences for a transfer of an annuity issued before April 23, 1987 are more complex. Any annuity gains that the transferor realizes are taxed in the year the contract was surrendered by the recipient, not the year the gift was made.

Example(s):

Mr. Smith wants to gift an annuity to his daughter Alexandra. Mr Smith purchased the annuity contract before April 23, 1987. He has put USD 12,000 in premiums into the annuity, which has a cash surrender value of USD 20,000. At age 21 Mr. Smith gives the annuity to his daughter. So Alexandra does not surrender the annuity until age 25. Mr. Smith would not be taxed on gains from the annuity (USD 20,000 cash surrender value minus USD 12,000 premiums paid into the annuity) until the year the annuity was surrendered-four years after he gave the annuity to his daughter.

Natural Person Requirement

Until 1986, the earnings on an annuity were tax-deferred regardless of the annuity owner's status as a natural person. In 1986 Congress passed legislation preventing certain corporations and others from taking advantage of the tax-deferred status that annuities enjoy. After February 28, 1986, if the contribution is to an annuity owned by a corporation or other legal entity other than a natural person, the annual earnings on the annuity funds are generally included in the owner's taxable income. But even so, the non-natural person rule is not applicable when a trust, corporation or other non-natural person holds an annuity contract on behalf of a natural person. Essentially, the contract is an annuity with tax-deferred earnings. Also, Caterpillar employees should know the non-natural person rule does not apply to the following types of annuities:

Acquired by the estate of a deceased individual.

Located in a qualified retirement plan, tax-sheltered annuity (TSA) or individual retirement account (IRA).

Purchased from a Caterpillar-sponsored plan at the termination of a qualified retirement plan or TSA program and held by Caterpillar until all amounts under the contract are distributed to the employee (or his/her beneficiary) for whom the contract was purchased.

An immediate annuity (an annuity purchased with a single premium that begins to pay within a year of purchase and which pays substantially equal periodic payments at least annually during the annuity period):

Qualified funding asset (e.g., a contract for an annuity with a licensed insurance company that is purchased to fund payments for personal physical injury or illness-related damages):

Estate Taxation of Annuities

Annuity contract values are usually included in the aggregate estate of a deceased policyholder. When the annuity owner dies before payments start, the annuity value is equal to the accumulated cash value. If payments began at the time of the annuity holder's death, this is the value of any remaining payments, if any. When annuity is owned jointly by unmarried individuals, the value included in gross estate is proportionate to each owner's contribution. For any Caterpillar employee with an annuity, the following information may be helpful in planning for your future and ensuring that your assets are passed to the intended beneficiaries when you die.

Example(s):

Bill paid 60 per cent of the premiums on an annuity and his cousin Ed 40 percent. Since Bill paid 60 percent of the premiums, only 60 percent of the annuity value will be included in Bill's gross estate when he dies. When Ed dies, 40 percent of that value will go into his gross estate.

If the proprietors are married, each spouse gets half of the property value as a gross estate.

Example(s):

And Bill paid 60 percent of the premium on a new annuity; his wife Cindy paid the other 40 percent. Bill will receive only 50 percent of the contract value in his gross estate when he dies despite paying 60 percent of the premiums. When Cindy dies, 50 percent of the value will be included in her gross estate even though she contributed only 40 percent of the premiums.

Example(s):

But if the decedent gifts an annuity contract to another person before death and the decedent has no interest in either the contract or the annuitization payments, the annuity contract value generally is not included in the decedent's estate.

Annuities Gifted After the Annuitization Starting Date are subject to Gift Taxation.

As a Caterpillar employee, you may be required to pay federal gift tax on an annuity you gift. When someone buys an annuity and later gifts it to someone else, the gift is worth the cost of the annuity contract. If the buyer of an annuity contract keeps the contract for some time before gifting it and additional payments are needed to maintain the contract, it is a little more complicated to determine the gift value. The gift equals the interpolated terminal reserve value plus the proportional share of the most recent premium payment for the period beyond the date of death.

Tip:

The annual gift tax exclusion could apply.

In terms of the taxation of annuities, our 60-something audience of Caterpillar workers and retirees needs to know that annuity contracts owned by non-natural persons such as corporations are subject to different tax rules. If a contribution is made after February 28, 1986 to an annuity owned by a non-natural person, the annual earnings on the annuity's funds are generally included in the owner's taxable income, under Internal Revenue Code Section 72 (u) (1). That means if you have an annuity held in a corporation or other non-natural person entity, know the tax implications. Be educated and consult a tax professional for specific advice tailored to your situation. (Source: IRS, Publication 575 - Pension and Annuity Income (December 30, 2021).

It is like navigating a financial maze to understand how annuities are taxed. As explorers with maps and terrain knowledge might conquer a maze of terrain, our 60-something audience of Caterpillar workers and retirees needs information on annuity taxation to make sound decisions. Think of annuities like financial structures with many different paths to explore. From the non-deductible premiums that resemble financial checkpoints without immediate tax benefits to the tax-deferred growth on annuity earnings that resemble treasures yet to be found - every turn and turn has potential tax consequences. Be wary of penalties and rules regarding withdrawals, partial or full surrenders, distributions and even gifting annuities. Just as seasoned explorers seek out expert help in unfamiliar terrain, so should our intended audience seek out tax professionals to help them decipher the annuity tax maze and direct their money to the best possible destinations.

Sources:

1. Internal Revenue Service.  'Publication 575 (2023), Pension and Annuity Income.' IRS, 2023. Web. Accessed February 2023.  Publication 575 .

2. Internal Revenue Service.  'Topic No. 410, Pensions and Annuities.' IRS, n.d. Web. Accessed February 2023.  Topic No. 410 .

3. Internal Revenue Service.  'Publication 939 (12/2022), General Rule for Pensions and Annuities.' IRS, December 2022. Web. Accessed February 2023.  Publication 939 .

4. Internal Revenue Service.  'Annuities - A Brief Description.' IRS, n.d. Web. Accessed February 2023.  Annuities - A Brief Description .

5. Internal Revenue Service.  'Form 1040 and Instructions.' IRS, 2023. Web. Accessed February 2023.  Form 1040 Instructions .