Back to Annuity Rules Variable Annuities

Annuity Rules: Variable Annuities

  • 549. Is the purchaser of a deferred variable annuity taxed on the annual growth of a deferred annuity during the accumulation period?

    • An annuity owner who is a “natural person” will pay no income tax until he or she receives distributions from the contract. If the contract is annuitized, taxation of payments will be calculated based on the rules that apply given the annuity starting date when payments begin. Distribution amounts received “not as an annuity” – i.e., partial withdrawals or full surrenders without annuitization – prior to the annuity starting date are subject to the rules discussed in Q 515 and Q 523.

      The tax deferral enjoyed by a deferred annuity owned by a natural person is not derived from any specific IRC section granting such deferral. Rather, this tax treatment is granted by implication. All distributions from an annuity are either “amounts received as an annuity” or “amounts not received as an annuity.” As the annual growth of the annuity account balance, except to the extent of dividends, is not stated in the IRC to be either, it is not a “distribution,” and therefore is not subject to tax as earned. For the tax treatment of dividends, see Q 515, Q 525, and Q 526.

      A variable annuity contract will not be treated as an annuity and taxed as explained in this and the following questions unless the underlying investments of the segregated asset account are “adequately diversified,” according to IRS regulations (Q 553).1


      Planning Point: Notably, this does not necessarily mean that investors themselves who own such variable annuities must be diversified, but simply that they must be presented with a diversified range of options from the variable annuity contract.


      If the owner of the contract is a person other than a natural person (for example, a corporation or certain trusts), growth in the value of the annuity might not be tax deferred; see Q 513.


      1.      IRC § 817(h); Treas. Reg. § 1.817-5.

  • 550. How are payments under a variable immediate annuity taxed?

    • Both fixed dollar and variable annuity payments received as an annuitized stream of income are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser’s investment, and the balance is taxable as ordinary income. In the case of a variable annuity, however, the excludable portion is not determined by calculating an “exclusion ratio” as it is for a fixed dollar annuity (Q 527). Because the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. Thus, the excludable portion of each payment is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid.1 In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.

      If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If payments are to be made for a single life, the divisor is the appropriate life expectancy multiple from Table I or Table V, whichever is applicable (depending on when the investment in the contract was made). If payments are to be made on a joint and survivor basis, based on the same number of units throughout both lifetimes, the divisor is the appropriate joint and survivor multiple from Table II or Table VI, whichever is applicable (depending on when the investment in the contract is made). IRS regulations explain the method for computing the exclusion where the number of units is to be reduced after the first death. The life expectancy multiple need not be adjusted if payments are monthly. If they are to be made less frequently (annually, semi-annually, quarterly), the multiple must be adjusted (see Frequency of Payment Adjustment Table, Appendix A).2

      A portion of each payment is only excluded from gross income using the exclusion ratio until the investment in the contract is recovered (normally, at life expectancy).3 However, if payments received are from an annuity with a starting date that was before January 1, 1987, payments continue to receive exclusion ratio treatment for life, even if the total cost basis recovered exceeds the original investment amount.

      Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of the year’s exclusion.4

      If an annuity settlement provides a period-certain or refund guarantee, the investment in the contract must be adjusted before being prorated over the payment period (Q 551).


      1.      Treas. Reg. § 1.72-2(b)(3).

      2.      Treas. Reg. §§ 1.72-2(b)(3), 1.72-4(d).

      3.      IRC § 72(b)(2).

      4.      Treas. Reg. § 1.72-2(b)(3).

  • 551. How is the value of a refund or period-certain guarantee determined under a variable annuity contract?

    • If a variable annuity settlement provides a refund or period-certain guarantee, then when calculating the exclusion ratio the investment in the contract must be reduced by the value of the guarantee.1 The value of such a guarantee in connection with a single life annuity is determined as follows:

      Find the refund percentage factor in Table III or Table VII (whichever is applicable, depending on the date the investment in the contract was made) under the age and (if applicable) sex of the annuitant and the number of years in the guaranteed period. Where the settlement provides that proceeds from a given number of units will be paid for a period-certain and life thereafter, the number of years in the guaranteed period is clear (e.g., 10, 15, 20 “years certain”).

      If the settlement specifies a guaranteed amount, however, divide this guaranteed amount by an amount determined by placing payments received during the first taxable year (to the extent that such payments reduce the guaranteed amount) on an annual basis. Thus, if monthly payments begin in August, the total amount received in the first taxable year is divided by five, then multiplied by 12.

      The quotient is rounded to the nearest whole number of years, and is used in entering Table III or Table VII, as applicable. The appropriate Table III or Table VII multiple is applied to whichever is smaller: (a) the investment in the contract, or (b) the product of the payments received in the first taxable year, placed on an annual basis, multiplied by the number of years for which payment of the proceeds of a unit or units is guaranteed. The following illustration is taken from the regulations:2

      Example: Mr. Brown, a 50 year old male, purchases, for $25,000, a contract that provides for variable monthly payments to be paid to him for his life. The contract also provides that if he should die before receiving payments for 15 years, payments shall continue according to the original formula to his estate or beneficiary until payments have been made for that period. Beginning with the month of September, Mr. Brown receives payments that total $450 for the first taxable year of receipt. This amount, placed on an annual basis, is $1,350 ($450 divided by 4 or $112.50; $112.50 multiplied by 12, or $1,350).

      If there is no post-June 1986 investment in the contract, the guaranteed amount is considered to be $20,250 ($1,350 × 15), and the multiple from Table III (for male 50, 15 guaranteed years), nine percent, applied to $20,250 (because this amount is less than the investment in the contract), results in a refund adjustment of $1,822.50. The latter amount, subtracted from the investment in the contract of $25,000, results in an adjusted investment in the contract of $23,177.50. If Mr. Brown dies before receiving payments for 15 years and the remaining payments are made to Mr. Green, his beneficiary, Mr. Green shall exclude the entire amount of such payments from his gross income until the amounts so received by Mr. Green, together with the amounts received by Mr. Brown and excludable from Mr. Brown’s gross income, equal or exceed $25,000. Any excess and any payments thereafter received by Mr. Green shall be fully includable in gross income.

      Assume the total investment in the contract was made after June 30, 1986. The applicable multiple found in Table VII is three percent. When this is applied to the guaranteed amount of $20,250, it results in a refund adjustment of $607.50. The adjusted investment in the contract is $24,392.50 ($25,000 – $607.50).


      1.      Treas. Reg. § 1.72-7(d).

      2.      Treas. Reg. § 1.72-7(d)(2).

  • 552. If payments from an immediate variable annuity drop below the excludable amount for any year, is the balance of the exclusion lost?

    • No.

      If the amount received from an immediate variable annuity in any taxable year is less than the excludable amount as originally determined, the annuitant may elect to redetermine the excludable amount in a succeeding taxable year in which the annuitant receives another payment. The aggregate loss in exclusions for the prior year (or years) is divided by the number of years remaining in the fixed period or, in the case of a life annuity, by the annuitant’s life expectancy computed as of the first day of the first period for which an amount is received as an annuity in the taxable year of election. The amount so determined is added to the originally determined excludable amount.1


      Planning Point: This rule allows any investment in the contract not received in one year to be recovered pro-rata in subsequent years as subsequent payments are received.


      Example 1: Mr. Brown is 65 years old as of his birthday nearest July 1, 1985, the annuity starting date of a contract he purchased for $21,000. There is no investment in the contract after June 30, 1986. The contract provides variable monthly payments for Mr. Brown’s life. Because Mr. Brown’s life expectancy is 15 years (Table I), he may exclude $1,400 of the annuity payments from his gross income each year ($21,000 ÷ 15). Assume that in each year before 1988, he receives more than $1,400, but in 1988, he receives only $800 – $600 less than his allowable exclusion. He may elect, in his return for 1989, to recompute his annual exclusion. Mr. Brown’s age, as of his birthday nearest the first period for which he receives an annuity payment in 1989 (the year of election) is 69, and the life expectancy for that age is 12.6. Thus, he may add $47.61 to his previous annual exclusion, and exclude $1,447.61 in 1989 and subsequent years. This additional exclusion is obtained by dividing $600 (the difference between the amount he received in 1988 and his allowable exclusion for that year) by 12.6.

      Example 2: Mr. Green purchases a variable annuity contract that provides payments for life. The annuity starting date is June 30, 2022, when Mr. Green is 64 years old. Mr. Green receives a payment of $1,000 on June 30, 2023, but receives no other payment until June 30, 2024. Mr. Green’s total investment in the contract is $25,000. Mr. Green’s pre-July 1986 investment in the contract is $12,000. Mr. Green may redetermine his excludable amount as above, using the Table V life expectancy. If, instead, he elects to make separate computations for his pre-July 1986 investment and his post June-1986 investment, his additional excludable amount is determined as follows.

      Pre-July 1986 investment in the contract allocable to taxable years 2023 and

      2024 ($12,000 ÷ 15.1 [multiple from Table I for a male age 64] = $794.70;

      $1,589.40
      Less: portion of total payments allocable to pre-July 1986 investment in the

      contract actually received as an annuity in 2023 and 2024 ($12,000/$25,000

      × $1,000)

      480.00
      Difference $1,109.40
      Post-June 1986 investment in the contract allocable to taxable years 2023 and 2024
      ($13,000 ÷ 20.3 [multiple from Table V for male age 64] = $640.39; $640.39 ×
      2 years = $1,280.78
       $1,280.78
      Less portion of total payments allocable to post-July 1986 investment in the

      contract actually received as an annuity in 2023 and 2024 ($13,000/$25,000 ×

      $1,000)

      520.00
      Difference $ 760.78

      Because the applicable portions of the total payment received in 2023 under the contract ($480 allocable to the pre-July 1986 investment in the contract and $520 allocable to the post-June 1986 investment in the contract) do not exceed the portion of the corresponding investment in the contract allocable to the year ($794.70 pre-July 1986 and $640.39 post-June 1986) the entire amount of each applicable portion is excludable from gross income and Mr. Green may redetermine his excludable amounts as follows:

      Divide the amount by which the portion of total payment actually received allocable
      to pre-July 1986 investment in the contract is less than the pre-July 1986 investment in the contract allocable to 2023 and 2024 ($1,109.40) by the life expectancy under Table I for Mr. Green, age 66 (14.4 – .5 [frequency multiple]; $1,109.40 ÷ 13.9)
      $ 79.81
      Add the amount originally determined with respect to pre-July 1986 investment in

      the contract

      794.70
      Amount excludable with respect to pre-July 1986 investment $874.51
      Divide the amount by which the portion of total payment actually received allocable

      to post-June 1986 investment in the contract is less than the post-June 1986

      investment in the contract allocable to 2023 and 2024 ($760.78) by the life

      expectancy under Table V for Mr. Green, age 66 (19.2 – .5 [frequency multiple];

      $760.78 ÷ 18.7)

      $ 40.68
      Add the amount originally determined with respect to post-June 1986 investment in

      the contract

      640.39
      Amount excludable with respect to post-June 1986 investment $681.07

      1.      Treas. Reg. § 1.72-4(d)(3).

  • 553. What is a wraparound or investment annuity? How is the owner taxed prior to the annuity starting date?

    • “Investment annuity” and “wraparound annuity” are terms for arrangements in which an insurance company agrees to provide an annuity funded by investment assets placed by or for the policyholder with a custodian (or by investment solely in specifically identified assets held in a segregated account of the insurer). The IRS has ruled that under these arrangements, sufficient control over the investment assets is retained by the policyholder so that income on the assets prior to the annuity starting date is currently taxable to the policyholder rather than to the insurance company, which is actually favorable in this context – it means investors can retain capital gains treatment on the underlying assets, even as they receive the guarantees associated with the annuity backing, though it also means the investor does not receive the annuity’s tax deferral benefits.1

      In some instances, however, the policyholder’s degree of control over the investment decisions has been insufficient, so the IRS considered the insurance company, rather than the policyholder, to be the owner of the contracts. For example, the IRS has ruled that the contract owner of a variable annuity can invest in sub-accounts that invest in mutual funds that are available only through the purchase of variable contracts without losing the variable annuity’s tax deferral, but in turn will be forced to have all gains taxed as ordinary income (per the usual treatment of annuity gains).2

      The IRS has ruled on whether the hedge funds within the sub-accounts of variable annuities and variable life insurance contracts will be treated as owned by the insurance company or the contract owner. Generally, if the hedge funds are available to the general public, the sub-account will be treated as owned by the contract owner and therefore not entitled to tax deferral. However, if the hedge funds are available only through an investment in the variable annuity, tax deferral is available.3 The IRS also has clarified who is considered the “general public.”4

      With the exception of certain contracts grandfathered under Revenue Rulings 77-85 and 81-225, the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in the Regulations.5


      1.      Christoffersen v. U.S., 84-2 USTC ¶ 9990 (8th Cir. 1984), rev’g 84-1 USTC ¶ 9216 (N.D. Iowa 1984), cert. denied, 473 U.S. 905 (1985); Rev. Rul. 81-225, 1981-2 CB 12 (as clarified by Rev. Rul. 82-55, 1982-1 CB 12); Rev. Rul. 80-274, 1980-2 CB 27; Rev. Rul. 77-85, 1977-1 CB 12.

      2.      Rev. Rul. 2005-7, 2005-6 IRB 464. See also Rev. Rul. 2003-91, 2003-33 CB 347; Rev. Rul. 82-54 1982-1 CB 11.

      3.      Rev. Rul. 2003-92, 2003-33 CB 350.

      4.      Rev. Rul. 2007-7, 2007-7 IRB 468.

      5.      IRC § 817(h); Treas. Reg. § 1.817-5.

  • 554. What is a private placement variable annuity (PPVA)?

    • A PPVA investment is an annuity that is available only to high net worth individuals who qualify as accredited investors (and, practically, qualified purchasers), meaning that they meet certain requirements as to net worth and investment sophistication. It is an annuity in that it is treated as such for tax purposes, but the similarities to the traditional retail annuities that most taxpayers associate with the term ends there—PPVA investments do not offer the types of income guarantee riders and protection against market risks that today’s retail annuities typically make available.

      Instead, the draw of the PPVA investment is the investment flexibility and tax-deferred growth that these types of accounts offer. The taxpayer has the freedom to made additional deposits to the annuity and change his or her investment allocations based on a number of investment options—typically, these annuities will provide a choice of investments that includes non-traditional investment options, such as hedge fund and private equity investments that have the potential to generate substantial returns.

      Taxes on the account growth are deferred until the taxpayer begins taking annuity payouts (a 10 percent penalty charge applies if distributions begin before the taxpayer reaches age 59½). In order to qualify for this favorable tax treatment, the PPVA investment must offer only investment options that are available solely to qualified insurance companies.

      Further, the underlying asset allocations must meet certain investment diversification requirements—for example, no more than 55 percent of the individual’s assets may be allocated to any single investment and no more than 70 percent may be allocated to any two investments. The taxpayer has control over his or her investment allocations, but cannot have control over the investment choices that are offered within the PPVA investment—an independent investment manager must have discretion to choose the investments that will be made available to the taxpayer.

  • 555. What is the difference between a longevity annuity and a deferred annuity?

    • A deferred annuity provides for an initial waiting period before the contract can be annuitized (usually between one and five years), and during that period the contract’s cash value generally remains liquid and available (albeit potentially subject to surrender charges). Beyond the initial waiting period the contract may be annuitized, though the choice remains in the hands of the annuity policyowner, at least until the contract’s maximum maturity age (at which point it must be annuitized).

      By contrast, a longevity annuity generally provides no access to the funds during the deferral period, and does not allow the contract to be annuitized until the owner reaches a certain age (usually around 85).

      In other words, many taxpayers purchase traditional deferred annuity products with a view toward waiting until old age to begin annuity payouts, but they always have the option of beginning payouts at an earlier date. With a longevity annuity, there is generally no choice, but this also allows for larger payments for those who do survive to the starting period; as a result, for those who survive, longevity annuities typically provide for a larger payout (often, much larger) than traditional deferred annuity products.

      Most taxpayers who purchase longevity annuities do so in order to insure against the risk of outliving their traditional retirement assets. The longevity annuity, therefore, functions as a type of safety net for expenses incurred during advanced age. Where a deferred annuity contract may be more appropriately categorized as an investment product, the primary benefit of a longevity annuity is its insurance value.

  • 556. What is a qualified longevity annuity contract (QLAC)? What steps has the IRS taken to encourage the purchase of QLACs?

    • A qualified longevity annuity contract (QLAC) is a type of longevity annuity (“deferred income annuity”) that meets certain IRS requirements that have been developed in order to encourage the purchase of annuity products with retirement account assets.1 A QLAC is a type of deferred annuity product that is usually purchased before retirement, but for which payouts are delayed until the taxpayer reaches old age.


      Planning Point: Some commentators make a distinction between “longevity annuities” in regard to the annuity starting date (ASD). This is because some contracts specify a particular ASD, such as age 85, while others offer the purchaser a choice of ASDs. The former variety typically provides no pre-ASD death benefit and the latter may.


      In the usual case, if a deferred annuity is held in a retirement plan, the value of that contract is included in determining the amount of the account owner’s required minimum distributions (RMDs).2 One of the primary benefits of a QLAC is that the IRS’ rules allow the value of the QLAC to be excluded from the account value for purposes of calculating RMDs.3 Because including the value of a QLAC in determining RMDs could result in the taxpayer being forced to begin annuity payouts earlier than anticipated if the value of his or her other retirement accounts has been depleted, the IRS determined that excluding the value from the RMD calculation furthers the purpose of providing taxpayers with predictable retirement income late in life.4

      Under the SECURE Act 2.0, plans may implement a “free-look period” of up to 90 days, during which the taxpayer can rescind the purchase of the QLAC without penalty.

      The amount that a taxpayer can invest in a QLAC and exclude from the RMD calculation is limited, however, to the lesser of $145,000 (as adjusted for inflation in 2022, the amounts were $130,000 for 2018-2019 and $135,000 for 2020-2021) or 25 percent of the taxpayer’s retirement account value.5 In 2023-2024, the limitations for QLAC investments are $200,000 (the amount will be indexed for inflation) and the 25 percent limitation was removed under the SECURE Act 2.0.

      Prior to the SECURE Act 2.0, final regulations provided that the 25 percent limit was based upon the account value as it existed on the last valuation date before the date upon which premiums for the annuity contract were paid. This value was increased to account for contributions made during the period that began after the valuation date and ended before the date the premium was paid. The account value was decreased to account for distributions taken from the account during the same period.6

      To qualify as a QLAC, the annuity contract must also provide that annuity payouts will begin no later than the first day of the month following the month in which the taxpayer reaches age 85.7 Variable annuities, indexed annuities and similar products may not qualify as QLACs unless the IRS specifically releases future guidance providing otherwise.8 Further, a QLAC cannot provide for any commutation benefit, cash surrender value or similar benefit.9

      Taxpayers also have the option of choosing a joint payout option to benefit a surviving spouse or a lump sum distribution to beneficiaries if the QLAC payments are never needed.  Once QLAC payments begin, the amounts are subject to ordinary income tax just like any other traditional retirement account distribution.

      The SECURE Act 2.0 clarified that if the QLAC was purchased with joint and survivor annuity benefits for the individual and a spouse, and assuming that the contract was permissible under regulations in place at the time of purchase, a divorce occurring after the original purchase and before annuity payments begin will not impact the permissibility of the joint and survivor annuity benefits.  Further, the divorce will not impact any other benefits under the contract (or require any adjustment to the amount or duration of the benefits).

      That is the case provided that a qualified domestic relations order (QDRO) either (1) provides that the former spouse is entitled to the survivor benefits under the contract, (2) provides that the former spouse is treated as a surviving spouse for purposes of the contract, (3) does not modify the treatment of the former spouse as the beneficiary under the contract who is entitled to the survivor benefits, or (4) does not modify the treatment of the former spouse as the measuring life for the survivor benefits under the contract.


      1.      2012-13 IRB 598.

      2.      Treas. Reg. § 1.401(a)(9)-6, A-12.

      3.      See IRC § 401(a)(9).

      4.      2012-13 IRB 598.

      5.      2012-13 IRB 598.

      6.      Treas. Reg. §1.401(a)(9)-6, A-17(d)(1)(iii).

      7.      Treas. Reg. § 1.401(a)(9)-6, A-17(a).

      8.      Treas. Reg. § 1.401(a)(9)-6, A-17(a)(7).

      9.      Treas. Reg. § 1.401(a)(9)-6, A-17(a)(4).

  • 557. What types of retirement accounts can hold a qualified longevity annuity contract (QLAC)?

    • A qualified longevity annuity contract (QLAC, see Q 556) may be held in a qualified defined contribution plan (such as a 401(k) plan), IRC Section 403 plans, traditional IRAs and individual retirement annuities under Section 408, and eligible IRC Section 457 governmental plans.1

      An annuity purchased within a Roth IRA cannot quality as a QLAC. If a QLAC is purchased under a traditional IRA or qualified plan that is later rolled over or converted to a Roth IRA, the annuity will not be treated as a QLAC after the date of the rollover or conversion.2 While it is true that an annuity purchased in a Roth IRA cannot qualify as a QLAC, it should not be assumed that a Roth IRA cannot purchase a longevity annuity. The final regulations do not prohibit this.


      1.      Treas. Reg. § 1.401(a)(9)-6, A-17(b)(2).

      2.      Treas. Reg. § 1.401(a)(9)-6, A-17(d)(3)(ii).

  • 558. Can a taxpayer purchase both QLACs and non-QLAC DIAs within an IRA and remain eligible to exclude the QLAC value when calculating RMDs? How is the non-QLAC DIA treated in such a case?

    • The regulations answer this question by their focus: only QLACs are addressed within the regulations. IRA-held DIAs that are not QLACs are not governed by the new regulations. These regulations are additive in that they do not remove any of the previously existing rules that govern these types of annuity contracts. As a result, the regulations do not prevent a taxpayer from holding a non-QLAC DIA in a traditional IRA. In such a case, the previously existing method for determining RMDs for non-QLAC DIAs will apply.

      The actuarial present value [APV] (which may be referred to as fair market value [FMV]) is calculated and RMDs attributable to that value must be withdrawn from another IRA or through a commutation liquidation from the DIA contract itself. After the annuity starting date, the income payments from the DIA automatically satisfy the RMD requirement. No separate calculation is required.

  • 559. May an individual purchase a QLAC after the required beginning date (RBD)?

    • The Treasury Department answers this question by implication in revised Treasury Regulation Section 1.401(a)(9)-6, A-17(c)(v), which states that, for contracts permitting a set non-spousal beneficiary designation, “payments are payable to the beneficiary only if the beneficiary was irrevocably designated on or before the later of the date of purchase or the employee’s required beginning date.” Based upon this language, it is clear that an employee (in the case of a qualified plan) or IRA participant may purchase a QLAC after his or her RBD.


      Planning Point: The final regulations do not answer the following question: Can a QLAC in a qualified plan be converted to a traditional IRA?


      At this point in time, the answer to this question may depend upon the insurers’ administrative systems.

  • 560. Are the death benefits under a deferred annuity triggered upon the death of the owner of the annuity, or upon the death of the annuitant?

    • Whether death benefits of a deferred annuity (in particular, certain guaranteed minimum death benefits in excess of the contract’s cash value) are triggered upon the death of the owner or the annuitant depends upon the terms of the contract. Some deferred annuity contracts are “annuitant-driven”, meaning that the contract will be paid out upon the death of the annuitant. These contracts will pay the death benefit (including any guaranteed minimum death benefit) upon the death of the annuitant.

      However, all deferred annuity contracts issued since January 18, 1985,1 must specify that if any “holder” of a deferred annuity contract dies before the contract enters payout status, the entire interest must be distributed within five years of the holder’s death. Thus, all such contracts are “owner-driven” while only some are also “annuitant-driven”. Typically, the “holder” of the annuity contract is the owner of that contract, though if the annuity owner is a non-natural person (such as a trust or a corporation), the holder of the contract is the primary annuitant under the contract.2 See Q 565.

      In practical terms, this means that if a deferred annuity contract is “annuitant-driven” and provides for a guaranteed minimum death benefit in excess of the contract’s cash value and if the owner and annuitant are not the same person, the cash value will be paid out if the owner dies first (ending the contract) and the guaranteed minimum death benefit will be paid out if the annuitant dies first. If a contract is not “annuitant-driven”, the death benefit will be paid out only upon the death of the first owner (“holder”). In that situation, if the annuitant dies first, the owner may generally name a new annuitant. If the owner and annuitant are the same person (the annuitant must be a human being), this question is moot.


      1.      IRC § 72(s)(1)(B).

      2.      IRC § 72(s)(6)(A).

  • 561. What are the rules that allow 401(k) plan sponsors to include deferred annuities in target date funds (TDFs)?

    • IRS Notice 2014-66 specifically permits 401(k) plan sponsors to include deferred annuities within TDFs without violating the nondiscrimination rules that otherwise apply to investment options offered within a 401(k). This is the case even if the TDF investment is a qualified default investment alternative (QDIA)—which is a 401(k) investment that is selected automatically for a plan participant who fails to make his or her own investment allocations.

      Further, the guidance clarifies that the TDFs offered within the plan can include deferred annuities even if some of the TDFs are only available to older participants—even if those older participants are considered “highly compensated”—without violating the otherwise applicable nondiscrimination rules. Similarly, the nondiscrimination rules will not be violated if the prices of the deferred annuities offered within the TDF vary based on the participant’s age.

      The IRS guidance will allow plan sponsors to include annuities within TDFs even if a wide age variance exists among the plan’s participants. Additionally, the rules allow plan sponsors to provide a participant with guaranteed lifetime income sources even if the participant is not actively making his or her own investment decisions with respect to plan contributions—a situation which is increasingly prevalent as employers may now automatically enroll an employee in the 401(k) plan unless the employee actively opts out of participation.

  • 562. What are the SECURE Act lifetime income rules designed to increase the use of annuities in 401(k)s?

    • The SECURE Act created a fiduciary safe harbor designed to increase the use of annuities to provide lifetime income within the 401(k). Plan sponsors can now satisfy their fiduciary obligations in choosing the annuity provider by conducting an objective, thorough and analytical search at the outset (eliminating the need for ongoing monitoring). The sponsor must also evaluate the insurance carrier’s financial capability to satisfy the annuity obligations, as well engage in a cost-benefit analysis with respect to the annuity offering (the sponsor is permitted to rely upon a written representation from the insurance company demonstrating the carrier’s financial standing). The written representation must state that the insurance company:

      • Is properly licensed,
      • Has met state licensing requirements for both the year in question and seven prior years,
      • Will undergo financial examination at least once every five years,
      • Will notify the plan fiduciary of any changes in status.1

      From this information, to qualify under the safe harbor, the plan sponsor must draw the conclusion that the carrier is financially capable and that the contract cost is reasonable—in other words, the plan sponsor must have no reason to believe the representations are false. The plan sponsor must also obtain updated written representations at least once a year.

      The plan sponsor must determine that the cost of the annuity option is reasonable in relation to the benefits and features provided by the annuity. There is no requirement that the plan sponsor choose the least expensive annuity option.2

      While this provision is expected to make it easier for plan sponsors to offer annuity options without fear of added fiduciary liability, the SECURE Act also makes the annuity portable once the plan participant has chosen the lifetime income option. Effective for tax years beginning after December 31, 2019, the annuity can be transferred in a direct trustee-to-trustee transfer between qualified plans (or between a qualified plan and an IRA) if the lifetime income option is removed from the original plan’s investment options.3 The option will be available to participants beginning 90 days prior to elimination of the annuity option from their current plan’s investment options (i.e., the portability window remains open for 90 days).4

      In connection with the anticipated expansion of annuities within 401(k)s, the SECURE Act also aims to give clients more information that can allow them to evaluate how the annuity option could work for them. Effective within 12 months after the DOL guidance was released in August 2020, defined contribution plans will be required to provide participants with lifetime income estimates. Plans must provide this statement at least annually even if the plan does not offer an annuity option.


      Planning Point: The DOL FAQ implement the interim final rule on the SECURE Act lifetime income illustration provisions. The FAQ clarifies that the earliest statement for which the illustrations are required is a statement for a quarter ending within 12 months of the rule’s effective date (i.e., September 18, 2021) if the plan issues quarterly statements. Therefore, the illustrations are timely if they were incorporated into any quarterly statement up to the second calendar quarter of 2022. For non-participant-directed plans, the lifetime income illustrations had to be included on the statement for the first plan year ending on or after September 19, 2021 (or, no later than October 15, 2022, which was the deadline for filing the annual return for a calendar year plan). The FAQ also clarifies that plans are permitted to provide additional lifetime income illustrations as long as the required illustrations are also provided, recognizing that some plans have been including illustrations for many years.


      The SECURE Act itself did not provide many details about what plan participants should expect. The DOL rule provides clarification.

      Under the DOL interim final rule, released in August 2020, 401(k) plans and other ERISA-covered defined contribution plans must show plan participants the estimated monthly payment they could receive based upon their account balance and life expectancy. The plan must also provide the information based on the life expectancy of a participant and a spouse—even if the participant is unmarried—assuming the participant and spouse are the same age. The spousal information must be presented as a qualified joint and survivor annuity (QJSA).

      In estimating the participant’s lifetime income stream, the plan must make certain assumptions. The information will assume that benefits begin at age 67 (or the participant’s actual age, if he or she has already reached age 67). The spousal benefit will be assumed to be 100 percent of the average monthly benefit during the time when both spouses are alive.

      The plan must use the interest rate for specified 10-year constant-maturity Treasury securities and the IRC Section 417(e)(3)(B) unisex mortality tables must be used to determine life expectancies (this is the same table used for most defined benefit plan lump-sum distributions).


      Planning Point: Clients should be advised that the current rules do not require plans to factor in the client’s age or any potential future earnings on the account balance. Therefore, many clients will see numbers that are much lower than they could realistically expect to receive.


      If the plan actually offers annuities, the actual interest rates can be used, although the uniform assumptions about age upon benefit commencement, marital status, etc. must still be used.

      Plans are also required to provide participants with certain explanations about all of this information. The DOL rule also contains model language that plans can use to satisfy their obligations and qualify for the fiduciary safe harbor with respect to annuity offerings.


      1.      ERISA § 404(e)(2).

      2.      ERISA § 404(e)(3).

      3.      IRC § 401(a)(38).

      4.      IRC § 401(k)(2)(B)(i)(VI).

  • 563. Can a taxpayer combine a deferred income annuity (“longevity annuity”) with a traditional deferred annuity product?

    • Yes. Insurance carriers have begun offering optional riders that can be attached to variable deferred annuity products in order to include the benefits of a deferred income (“longevity”) annuity within the variable annuity. These deferred income annuities allow the contract owner to withdraw portions of the variable annuity itself in order to fund annuity payouts late into retirement.

      Taxpayers must purchase the rider at the time the variable annuity is purchased and can then begin transferring a portion of the variable annuity accumulation into the deferred income component as soon as two years after the contract is purchased. When the taxpayer begins making transfers into the deferred component, he or she must also choose the beginning date for the deferred payments.

      The deferral period can be as brief as two years or, in some cases, as long as 40 years, giving taxpayers substantial flexibility in designing the product to meet their individual financial needs. Further, taxpayers can choose to transfer as little as around $1,000 at a time or as much as $100,000 to build the deferred income portion more quickly.

      The deferred income annuity rider can simplify taxpayers’ retirement income planning strategies in several important ways, not the least of which involves the ability to gain the benefits of both variable deferred and deferred income annuities within one single annuity package.

      This single-package treatment also allows taxpayers to avoid the situation where they wish to transition their planning strategies to eliminate the investment-type features common to variable annuity products into a product that allows for a definite income stream—a situation that commonly arises around the time when a taxpayer retires.

      Without the combination product, the taxpayer would traditionally be required to execute a tax-free exchange of the variable annuity contract for a deferred income annuity. Instead, the deferred income annuity rider allows the taxpayer to systematically transfer funds from the variable portion of the contract into the deferred income portion over time (though lump sum transfers are also permissible).

  • 564. Can a grantor trust own a deferred annuity contract? How is a deferred annuity owned by a grantor trust taxed?

    • A grantor trust can own a deferred annuity contract, but, in certain circumstances, the “non-natural person rule” of IRC Section 72(u) will cause the denial of the tax-deferral benefits to a deferred annuity owned by a trust. If annuity tax benefits are denied under the non-natural person rule, income on the annuity for any taxable year will be treated as ordinary income received.1 However, if a trust owns a deferred annuity contract as the agent for a natural person, Section 72(u) does not apply.2

      A revocable grantor trust will usually fall within this exception because the grantor (presumably a natural person) and the grantor trust are treated as one “person” for income tax purposes,3 and, moreover, because the property is generally held in trust specifically for that grantor. More generally, as long as the grantor trust (a non-natural person) owns the deferred annuity contract, and the primary beneficiaries of the trust are natural persons, the annuity contract should escape the non-natural person rule of Section 72(u).4 If significant interests in the trust are held by non-natural persons, however, it is possible that the trust will not qualify as an agent for a natural person.

      It should be noted that most insurers require that when the owner of their deferred annuity contract is a trust, the trust must also be the primary beneficiary of that contract.

      If the grantor trust is irrevocable, determining whether the trust is exempt from the non-natural person rule becomes more complicated because the grantor of the trust might not retain any right to the trust assets or income. In making the determination whether significant interests in the trust are held by natural or non-natural persons, it is important to determine who will receive the primary economic benefit of the trust assets.5

      The IRS has ruled privately that deferred annuity contracts owned by an irrevocable grantor trust established by an employer-corporation (a non-natural person) were held for the benefit of natural persons (the employees) because (1) the employee-beneficiaries of the trust would receive all of the trust income and (2) the employer held no future interest in the trust assets.6 Therefore, even though the actual grantor of the trust was a non-natural person, the deferred annuity contract was able to escape the non-natural person rule because the beneficiaries were natural persons.

      Note that immediate annuities are explicitly exempted from the non-natural person rule of IRC Section 72(u).7


      1.      IRC § 72(u)(1).

      2.      IRC § 72(u)(1)(B).

      3.      See IRC § 671.

      4.      Let. Ruls. 9316018, 9120024.

      5.      Let. Ruls. 200449011, 200449013, 200449014.

      6.      Let. Ruls. 9316018, 9322011.

      7.      IRC § 72(u)(3).

  • 565. If a grantor trust owns a deferred annuity and the grantor is not the annuitant, whose death triggers the annuity payout?

    • If an irrevocable grantor trust owns a deferred annuity and the grantor of the trust is not the annuitant, it is not clear whether payment of death proceeds will be triggered upon the death of the grantor or upon the death of the annuitant. The Code provides that the primary annuitant will be considered the “holder” of the contract if the owner is a non-natural person (e.g., a trust).1 Therefore, many experts argue that it is the death of the primary annuitant that triggers annuity payout.

      Others disagree, and argue that it is the grantor’s death that will trigger payout. This is because of the grantor trust rules, which treat the grantor of a trust and the trust itself as one individual for income tax purposes. Because the grantor is the owner of the trust assets for income tax purposes, many experts argue that the grantor should be treated as owner—or “holder”—for purposes of IRC Section 72(s). That said, this ambiguity applies only to deferred annuities owned by irrevocable grantor trusts. When the owner is a revocable trust, the grantor trust rules control (as the grantor is the “holder” for income tax purposes). Although that is also true when the trust is irrevocable and also a grantor trust, some authorities insist that the rule of IRC Section 72(s)(6)(A) controls, as the grantor of an irrevocable trust owning a deferred annuity does not have the unfettered control of that annuity contract that he would have were the trust revocable.

      At this point, the matter remains unresolved without any clarity or on-point guidance  from the IRS.


      1.      IRC § 72(s)(6)(A).