Excise Federal Tax Penalty

Past
TEFRA was the piece of tax legislation that reminded so many of us that an annuity is a long term retirement product since it introduced the excise tax penalty for annuities issued on or after August 14, 1982.

Present
Withdrawals and other distributions of taxable amounts will be subject to an income tax, and if taken prior to age 59.5, a 10% federal tax penalty may apply.

Fortunately, there can be ways to avoid the 10% tax penalty for dollars withdrawn and or distributed prior to age 59.5

• death or disability of owner
• substantially equal payments over one’s life expectancy
• an immediate annuity.

Evolution Effect
Without a doubt, tax legislation a) lessened the appeal of the use of the contingent annuitant provision in annuity contracts b) triggered more owner –driven annuity contracts, c) stimulated (along with other legislation) the growing popularity of Stretch IRAs, and d) changed what consumers could do after the first phase of their Split Annuity. (In other words they could not do a second split nor a 1035 exchange and split again between Immediate Certain Period Annuity and a Tax-deferred Annuity).

1035(a) Exchange
One unique tax advantage with annuities is that you can transfer money from one annuity to another annuity income tax-free. The section in the Internal Revenue Code that allows this is section 1035(a). However, great care should be given.

Here are 5 Important Steps To A 1035(a) Exchange

1. Assign the old annuity contract (if premiums are non-qualified) to the new insurance company.
2. Exchange the annuity (partial transfers possible).
3. If there are loans outstanding, repay loans before exchanging.
4. Parties designated in the old contract as owner, annuitant, and beneficiary should again be designated in the new contract.
5. Customers should consult with their tax advisor before the exchange.
   

Unfortunately, the ease of transferring money from one annuity to another has created instances where the exchange may not have been in the best interests of the consumer.

While the topic of replacements is discussed later, financial professionals are reminded here that the exchange or replacement must provide a substantial financial benefit to the consumer.

Grandfathering

Grandfathering is a term that has been added to some pieces of tax legislation that protects a product or concept from tax change. Should we ever imply or state to a consumer that future taxation will protect them? No, there have been instances where new tax legislation did not protect product or concepts from tax change. However, since we are in the financial services profession, we should be well-versed on the topic of Grandfathering and be able to cite some examples.