Annuities: Divide & Conquer

Understanding Those Economic Stimulus Rebates

In the weeks ahead, the U.S. Treasury begins sending those well-publicized Economic Stimulus payments to qualifying individuals. Here’s a quick

summary on who will be receiving those payments and a few tips to assure that opportunities are not overlooked.

                                                                                                       The maximum Rebate

For most individuals who file a return and pay tax, the rebate will be $600 for single filers and $1,200 in the case of a joint return. The rebate amount is
limited to the tax liability, as reported on the 2007 Form 1040. And for those with a dependent child under age 17, there will be an additional $300 per
child.

But upper income filers are subject to a phase-out. This phase-out is based on the taxpayer’s Adjusted Gross Income shown on the 2007 tax return.
As this income exceeds $75,000 for a single filer or $150,000 in the case of a joint return, the rebate begins to diminish at the rate of 5% of income. If a

single filer’s total income exceeds $87,000 or a joint filer’s income exceeds $174,000, the rebate is zero. For each qualifying dependent child of the

taxpayer, it takes another $6,000 of income before the rebates are totally phased out.

                                                                                                       The Minimum Rebate

For lower income filers, there is a minimum rebate of $300 per taxpayer or $600 in the case of a joint return. Unlike the general rebate discussed above,
this amount is not limited by the amount of income tax paid for the year. Rather, it will be sent to filers who have little or no tax.

 In general, this minimum rebate can be claimed by those who report at least $3,000 of wages and self-employment income, or at least $3,000 of Social

Security benefits, or those who report at least $1 of tax liability, because gross income exceeds the minimum filing threshold ($8,950 for  single

taxpayer income or $17,900 for joint filer income).

                                                                                                        The Opportunities

The minimum rebate is available to a large number of lower income individuals who normally are not required to file a tax return. But the IRS has
announced that a 2007 Form 1040 must be submitted in order to allow the U.S. Treasury to identify the individual as eligible for a rebate. The IRS

website has a simplified approach for these individuals, allowing them to submit a Form 1040A that only shows either a wage amount or gross Social

Security benefits in order to trigger the rebate. The Form 1040A can be submitted anytime before October 15, 2008.

Those with elderly parents who are normally non-filers or perhaps that non-dependent 24-year-old grad student are encouraged to submit a 2007
Form 1040A. Rebates also will be issued to the estates of those who died during 2007 and similarly may not have been required to file a Form 1040.
Again, the executor should submit a 1040A to document that at least $3,000 of Social Security benefits were received by that person while alive during

2007.

Annuuities: Divide and Conquer

For many individual investors, annuities have a feature that is very attractive:  tax deferral with the investor deciding when to access that deferred

income. The tax deferral arises because the growth in the cash value of the underlying investments is not taxable until either a cash withdrawal is

taken by the owner or a series of lifetime annuity payments are established. Most investors tend to hold their annuities and occasionally take

distributions in retirement as their needs dictate.

But withdrawals from annuities face a harsh tax reality:  any distributions are considered to first come from the deferred income. Only after all of the
deferred income has been withdrawn is the investor considered to receive a tax-free withdrawal of the original investment.

Example:      

Edna, age 80, owns an annuity acquired about 25 years ago that has a current market value of $200,000. Edna originally invested $50,000 in this annuity contract. To the extent that Edna takes any withdrawal amount up to $150,000, it will be considered to come from the deferred income portion of the annuity, and Edna will be required to report ordinary income in her Form 1040.

      

                                                                                           The Partial Exchange Strategy

The IRS has recently issued a Revenue Procedure that provides a strategy that may allow those holding highly appreciated annuities to arrange a

partial withdrawal that is not entirely ordinary income (Rev. Proc. 2008-24). This strategy relates to the ability to do a partial exchange of one annuity

into another, followed by a surrender of one of the annuity contracts 12 months later.

In general, it is permissible to accomplish a tax-deferred exchange of one annuity for another. Thus, an individual holding an annuity with a large

deferred gain could split that annuity, having the insurance company roll some portion of the cash value of the old annuity into a new annuity contract.

This is known as a Section 1035 exchange, and the result is simply to defer a proportionate amount of the gain into the new annuity contract. Using the
facts from the previous example, here’s how that strategy can be utilized:

Example:         

Edna, in the preceding example, surrenders half of the value of her large annuity and has the insurance company issue a second annuity worth

$100,000 (Edna’s old annuity is now also worth $100,000, as half of its cash value was rolled into the new annuity contract). As one would expect, the

tax cost in the annuity is also split proportionally, so that Edna has a $25,000 tax cost in each $100,000 annuity. But now, if Edna surrenders one of

the annuities in full, she receives a $100,000 distribution that is considered to be $25,000 of the return of her cost and $75,000 of ordinary income.

Previously, if Edna withdrew $100,000 from the single large annuity, it was considered entirely ordinary income.

                                                                                                  New IRS Safe Harbor

The new IRS Revenue Procedure allows a taxpayer to exchange an annuity into other annuity contracts and subsequently accomplish a surrender,

provided that the two transactions are separated by at least 12 months. As a result, if Edna’s split of the large annuity into two equal annuities

occurred on June 15, 2008, Edna would need to wait until after June 15, 2009, before she could surrender one of the annuities and apply its separate

cost recovery. This IRS safe harbor provides an important opportunity for those with large deferred annuities who might benefit from restructuring that

annuity into several smaller contracts.

 

Please consult us to find out exactly how the Economic Stimulus Package Act of 2008 will affect your personal and business taxes in 2008 at ltierney@marg.com.