Conflict information on non-qualified annuity taxable amount

[tdo061803]

My father's non-qualified annuity 1099-R states the entire distribution is taxable. The distribution code is 7D. The agent said because the distribution is all earnings. I show him IRS's General Rule and think a part of the distribution must be the principle and not taxable. He said that not how they do it in Prudential.

What the agent said is consistent with the company's Q&A.

https://www.annuities.prudential.com/view/page/investor/17095#11

Q.Why is my entire distribution taxable?

For Non-Qualified contracts there are 2 possible reasons:

• The distribution was all earnings; it did not contain any return of cost basis.

• The contract is aggregated.

But it's in conflict with what IRS's General Rule.

https://www.irs.gov/taxtopics/tc411#:~:text=The%20General%20Rule,tables%20that%20the%20IRS%20issues.

The General Rule

If you receive annuity payments from a nonqualified retirement plan, you must use the General Rule. Under the General Rule, you figure the taxable and tax-free parts of your annuity payments using life expectancy tables that the IRS issues.

He is confident about their 1099-R and has decline my requests to appeal the 1099-R.

Am I missing some special rules? If not, what are my options?

[SusanY1 · Accepted solution]

A non-qualified annuity and a non-qualified retirement plan are not the same thing. 

The general rule applies to non-qualified retirement plans paid as annuities but it doesn't apply to standard annuities. 

Your father's non-qualified annuity is not a non-qualified retirement plan.  It just simply an annuity that wasn't also a qualified plan of some sort (such as an IRA.) 

After a period of time, or in the case of certain types of annuities, the principal will be fully distributed and then the entire amount becomes taxable. 

While your Prudential representative perhaps didn't explain things very well, he is correct.  If the distribution was all earnings, then it is fully taxable. 

[sciaccamar]

I have strong doubts about the reply given, at least per the 2023 version of IRS Pubs 525 and 939.  I can find no distinction made about the General Rule between (non-qualified) annuities and retirement plans.  Instead, the salient distinction is between periodic payments and non-periodic (withdrawals).    The latter are not eligible for amortized cost recovery until all earnings are withdrawn, then return of invested capital takes place.

Pub939 states:  "In general, you can recover your net cost of the pension or annuity tax free over the period you are to receive the payments."  Also:  " An annuity is a series of payments under a contract made at regular intervals over a period of more than 1 full year. They can be either fixed (under which you receive a definite amount) or variable (not fixed). You can buy the contract alone or with the help of your employer.  Note. Distributions from pensions and annuities follow the same rules as outlined in this publication unless otherwise noted."

Unless someone can point out a specific IRS statement that excludes standard annuities from using the General Rule, I plan to use this approach and make an adjustment to the Taxable Amount that I believe was inaccurately reported in the 1099-R by the payer (insurance company).  

[NCperson]

@sciaccamar suggest asking the firm what the cost basis is in the annuity. if it has not changed, then all the payments you received are taxable.  if the cost basis has changed, you have an argument. 

It might be worth posting the details of your annuity as it is hard to either support your contention or refute it without that.  There are a number of examples of how this works in Pub 939 - did you read them? 

Personally, companies have lawyers and compliance experts that ensure these are contracts are reported correctly and adhere to law.  Do you have that level of expertise to make a different decision?  Since the IRS has a copy of that 1099-R already (as it is reported by the firm), if you tax return varies from that reporting, it risks an audit and / or withholding of any refund.  Best to discuss with the firm rather than just making your own decision.

[dmertz]

The General Rule can only be applied to periodic payments.  A portion of the investment in the contract is distributed with each periodic annuity distribution.  If an annuity for life pays out long enough, at some point all of the investment in the contract will have been paid out and distributions beyond that will be entirely taxable.  I think that that is what SusanY1 was referring to.

[sciaccamar]

Understood, perfectly, that basis return is capped at original investment amount.  In my case I have had only two annual distributions of a lifetime stretch

(death benefit payout of my mother's non-qualified annuity, which had never had any withdrawals or payments before she died.  Original basis was approximately 10% of cash / death benefit value at her passing, reflecting a long accumulation period.  This basis is confirmed by the customer service rep)

and the payer showed both as fully taxable.  Very similar to the Prudential situation in the original question.  Since Pubs 575 and 939 are very clear about applying the General Rule to periodic payments, including specific mention of death benefits for an inherited annuity, I can only guess that the annuity company is wrongly characterizing the payments as withdrawals (they actually show as "withdrawals" on the transaction confirmations).  I don't have much faith in corporate America to do the right thing for customers; if they can save a buck via simplification without undue compliance risk to the company they will do so.  Two separate customer phone support reps told me the earnings come out first, then at the end is basis returned.  They are obviously trained to say that instead of something about how their compliance department made a determination or a calculation on my specific annuity when deciding the payments are 100% taxable.   No specific reason or evidence for the fully taxable characterization has been given to me.  I have now requested details of their lifetime stretch calculation & resulting payment schedule so I have back-up to support my application of the General Rule.  Am I missing something here?

[sciaccamar]

@NCperson 

I have read the examples in Pub939 and concluded that conceptually the General Rule is a very simple straight line amortization of basis in the contract, until the basis allocation is depleted.  I cannot detect anything with respect to my case which would direct me to deviate from that approach. 

The publication also describes how I should address the deviation from the 1099-R:

"If you choose to refigure your tax-free amount, you must file a statement with your income tax return stating
that you are refiguring the tax-free amount in accordance with the rules of Regulations section 1.72-4(d)(3)"  I would imagine that TurboTax will generate this kind of statement, given that there is a question in the screen flow to allow self-determination of the taxable amount.  

I have given some details about my annuity payments in another post to this discussion today.   I hope those will be sufficient for you to understand my concerns.  

[dmertz]

"I can only guess that the annuity company is wrongly characterizing the payments as withdrawals"

This would explain the reporting.  If these payment are being received under a stretch provision where each payment is part of a series of periodic payments based on your life expectancy, yes, I would expect each payment to be treated as including a portion of the basis and this Form 1099-R would be showing an erroneous taxable amount.  Many annuity companies offer this beneficiary payout option and indicate that the exclusion ratio is one of the benefits of choosing this payout method.

Given that the Form 1099-R shows a taxable amount in box 2a and does not have box 2b Taxable amount not determined marked, using the General Rule to calculate a taxable amount different from what is reported on the Form 1099-R will likely cause the IRS to treat this as underreporting of taxable income which will require explanation.  The alternative would be to file a substitute Form 1099-R (Form 4852) where you could provide explanation for reporting the lower taxable amount calculated using the General Rule.