Tracking Cost Basis & Gain for Annuity Transactions

Deferred annuities and single premium immediate annuities (SPIA) are great financial vehicles for either tax-deferred accumulation of a retirement fund or efficient distribution of principal and interest over life expectancy.  However, over the lifetime of the contract owner, financial and estate planning situations occur which require a transaction to be executed on an existing annuity product.


These transactions could include annuitized settlement options, IRC Section 1035 exchanges, changes of ownership, payment to a beneficiary upon the death of the annuitant/owner, lifetime withdrawals from the annuity contract, etc.


To determine the income tax consequences, if any, when an annuity transaction occurs requires a tracking and verification of the “investment in the contract”.  We typically refer to this amount as the cost basis of the annuity.


Annuity Transactions with the Income Tax and Cost Basis Results are Itemized Below


    •    •Settlement option on an existing deferred annuity or the purchase of a new SPIA Determine the “exclusion ratio” based on the cost basis (investment in the contract) and the expected return.  Part of each annual payment will be excluded from income and part will be taxable income.  Once the cost basis has been fully recovered, any remaining payments will be 100% taxable income (IRC Section 72(b))


    •    •IRA Annuity A qualified plan account like an IRA has a zero ($0 ) cost basis.  Distributions from the IRA to the owner are 100% taxable income (IRC Section 72(e)(5))


    •    •Transfer of ownership of a deferred annuity from one spouse to another This type of transfer may occur for estate planning purposes or as a property settlement upon divorce.  In these cases, the cost basis is “carryover basis” and the transaction is tax-free with no current income taxes due (IRC Section 1041 and IRC Section 72(e)(4)(C)(ii)).


    •    •Transfer of IRA annuity upon divorce Again, a transfer of an IRA annuity incident to divorce is a tax-free transaction, and the cost basis is “carryover” basis to the other spouse (IRC Section 408(d)(6))


    •    •Gift of a deferred annuity contract to an adult child or an irrevocable trust Upon this change of ownership, the gain amount is taxable income to the donor and the new cost basis for the done is 100% of the account value (IRC Section 72(e)(4)(C)(i) and (iii))


    •    •IRC Section 1035 exchange of one deferred annuity contract for multiple deferred annuity contracts The exchange is tax-free, and the cost basis of the new contracts is allocated proportionally (IRC Section 1035(a)(3) and IRC Section 1031(d))


    •    •IRC Section 1035 “partial exchange” of annuity contract In this case, part of the annuity account is left with the existing carrier and part is exchanged to a new carrier.  The exchange is tax-free, and there is a proportional allocation of cost basis between the old and new contracts (Rev. Rul. 2003-76)


    •    •Death of the owner of a deferred annuity contract There is NO step-up in cost basis to date of death value.  The gain amount in excess of basis is “income in respect of decedent” (IRD) and is taxable income to the beneficiary (Rev. Rul. 2005-30; IRC Section 1014(b)(9)(A); IRC Section 691; IRC Section 72(s)


    •    •Withdrawals from a deferred annuity contract in a gain position Withdrawals are first “LIFO” taxable income to the extent of the gain in the contract. Any remaining withdrawals are a tax-free return of basis (IRC Section 72(e)(1)(2)(3)


    •    •Multiple deferred annuity contracts If multiple deferred annuity contracts are issued by the same insurance carrier, to the same contract owner, during the same calendar year, they will fall under the “aggregation rule”.  This means the multiple contracts will be treated as one annuity contract for purposes of any distribution that is includable in income (IRC Section 72(e)(12)). This “aggregation rule” does not apply to IRA annuities and Section 403(b) annuities.


    •    •Transfer of ownership of annuity contract under IRC Section 457(b) “eligible” deferred comp plan If an annuity contract held by a non-profit organization is transferred from the non-profit to an employee, 100% of the account value is taxable income and the new cost basis to the employee is 100% of the account value


    •    •Surviving spouse as post-death beneficiary of a deferred annuity If a surviving spouse is the beneficiary of a deferred annuity, he/she can take over the annuity and continue it as his/her own.  The cost basis is “carryover basis” and the surviving spouse can name a new beneficiary (IRC Section 72(s)(3)).  The surviving spouse can do a tax-free Section 1035 exchange if desired and keep tax deferral going all the way to the death of the surviving spouse.


    •    •Non-spouse as post-death beneficiary of a deferred annuity If a non-spouse is the beneficiary of a deferred annuity, they must elect a distribution payout either under the “5-year rule” (IRC Section 72(s)(1)(B)) or the “life expectancy rule”.  To qualify for a life expectancy payout, the beneficiary must make the election within one year of death.  Cost basis is “carryover basis” for purposes of post-death distributions.  The non-spouse may do a tax-free Section 1035 exchange to a new annuity carrier if desired and permitted by the carriers, but must maintain the life expectancy payout method (PLR 201330016; IRC Section 72(s)(2)(B))


    •    •Pre-59 ½ withdrawals from a deferred annuity Absent an exception, pre-59 ½ withdrawals from a deferred annuity in a gain position are subject to a 10% penalty tax.  This penalty tax is only applied to the gain amount in excess of cost basis (IRC Section 72(q)(1)).


    •    •Pre-59 ½ Section 1035 exchange from a deferred annuity to a SPIA For this type of exchange, the new SPIA will have an exclusion ration based on the “carryover basis” from the old deferred annuity.  However, the taxable amount of each SPIA payment will also be subject to the 10% penalty tax until the client reaches age 59 ½ because the transaction does not qualify for the immediate annuity exception (Rev. Rul. 92-95; IRC Section 72(q)(2)(I))



The scenarios described above are some of the more prominent annuity transactions that could appear from time to time over the financial lifetime of a client.  Contact your BSMG Annuity Advisor when planning annuity transactions for your clients.  We can advise on the structure, function, and taxation of any annuity product transaction so you can advise your clients.  Often, the client’s tax and legal advisors are not aware of the specifics involved when dealing with annuities.  We can help steer you in the right direction.


Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group