Taxation of Annuities For Dow Incorporated Employees

Income Taxation of Annuities

Income Taxation of Premiums

Generally, premiums (either a single payment or monthly installments paid over the course of many years) that you pay as a Dow Incorporated employee into an annuity are nondeductible. In other words, by placing funds within an annuity, you will not receive any current income tax savings. However, the earnings on the funds within the annuity will be tax deferred.

Caution:  Generally, annuity contracts have limitations, exclusions, fees, and charges which can include mortality and expense charges, account fees, investment management fees, administrative fees, charges for optional benefits, holding periods, termination provisions, and terms for keeping the annuity in force. Most annuities have surrender charges that are assessed if the contract owner surrenders the annuity. Withdrawals of annuity earnings are taxed as ordinary income and may be subject to surrender charges plus a 10% federal income tax penalty if made prior to age 59½. Withdrawals reduce annuity contract benefits and values. Any guarantees are contingent on the claims-paying ability and financial strength of the issuing company. [Annuities are not guaranteed by the FDIC or any other government agency; they are not deposits of, nor are they guaranteed or endorsed by, any bank or savings association.] For variable annuities, the investment return and principal value of an investment option are not guaranteed. Variable annuity subaccounts fluctuate with changes in market conditions, thus the principal may be worth more or less than the original amount invested when the annuity is surrendered.

Income Taxation of Earnings on Funds Within The Annuity (Cash Value Buildup)

Generally, the earnings within an annuity accumulate income-tax deferred, and the annuity owner will not be subject to income tax on such earnings until they are withdrawn. As a Dow Incorporated employee, you may want to keep this in mind when conducting financial planning and considering withdrawals.

Caution:  Early withdrawals from an annuity (prior to age 59½) will not only be subject to tax but may also trigger a federal 10 percent penalty.

Income Taxation of Distributions from an Annuity

Distributions (partial surrenders, full surrenders, or annuitization payments) that are categorized as earnings are treated as ordinary income for tax purposes. For Dow Incorporated employees, the income tax treatment of distributions from an annuity contract may vary based on the type of distribution method selected, and date the annuity contract was entered into.

Income Taxation of Partial Surrenders

If you are a Dow Incorporated employee and entered into an annuity contract after August 13, 1982, a partial surrender of the annuity is taxed under the interest-first rule. The interest-first rule treats the partial surrender as coming from the earnings portion of the annuity first (until all the earnings have been withdrawn), not the principal. As a result, the partial surrender that is from earnings is included in the annuity holder's gross income and is fully taxable.

If you entered into an annuity contract prior to August 14, 1982, a partial surrender of the annuity is generally taxed under the cost-recovery rule. The cost-recovery rule treats the partial surrender as coming from the investment in the contract first (until all the investment in the contract has been exhausted). The remainder of the partial surrender, if any, is treated as coming from the earnings on the contract and is treated as ordinary income.

Income Taxation of Complete Surrenders

If you are a Dow Incorporated employee and annuity holder, you may want to consider how if a holder completely surrenders an annuity, they become subject to income tax on the untaxed earnings (the difference between the cash surrender value of the contract and the net investment in the contract).

Example(s):  Mr. Smith owns an annuity that has a cash surrender value of $80,000 and has paid premiums equaling $30,000 into the annuity. When Mr. Smith completely surrenders the annuity, he will be subject to income tax on $50,000 ($80,000 - $30,000).

Calculating a Loss on an Annuity Contract

An annuity holder may suffer a loss if he or she sells or surrenders a variable annuity for less than its cost basis. This may occur if the market experiences a downturn and the value of the investment decreases.

Example(s):  Mr. Smith owns an annuity that has a cash surrender value of $80,000 and has paid premiums equaling $100,000 into the annuity. Mr. Smith completely surrenders the annuity, suffering a loss of $20,000.

Tip:  A loss on a variable annuity is classified as an ordinary loss under Rev. Rul. 61-201, 1961-2 C.B. 46, not an investment loss reported on Schedule D. How to take the loss is an unsettled area of tax law. One approach is to take the loss as a miscellaneous itemized deduction subject to the 2 percent floor on Schedule A. Another approach is to take the loss on Form 1040, other  Gains/Losses, deducting the full loss. Consult a tax professional. Any surrender charges incurred are not considered part of the loss.

Tip:  For a life only annuity with a starting annuitization date after July 1, 1986, a deduction may be taken for the unrecovered investment in the contract if the total of all payments received does not equal or exceed the investment in the contract.

Caution:  Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including the possibility of loss of principal. Variable annuities are sold by prospectus, which contains information about the variable annuity, including a description of applicable fees and charges. These include, but are not limited to, mortality and expense risk charges, administrative fees, and charges for optional benefits and riders. The prospectus can be obtained from the insurance company offering the variable annuity or from your financial professional. Read it carefully before you invest.

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Income Taxation of Annuity Payments

As a Dow Incorporated employee and potential annuity holder, it is imperative to understand the income taxation of annuity payments. The tax code treats payments received as an annuity as being divided into two parts: a nontaxable portion that represents the return of the premiums paid into the annuity and a taxable portion that represents the earnings on the annuity. As a result, only a portion (i.e., the premiums paid into the annuity) is excluded from the annuity owner's gross income. The portion of each annuity payment that is excludable is determined by multiplying the number of payments received each year by an exclusion ratio. The fixed annuity exclusion ratio equals:

The annuity holder's investment in the contract (at the annuitization starting date) divided by the expected return.

Example(s):  Mr. Smith has a fixed annuity contract that pays him $200 a month for 20 years. His expected return is $200/month x  20 years x 12 months/year = $48,000. Mr. Smith has an investment in the contract of $24,000, and his exclusion ratio is $24,000/$48,000 = 50 percent. As a result, 50 percent of each $200 payment ($100) would be excludable from Mr. Smith's gross income. The rest of his payment ($100) is treated as ordinary income.

Caution:  The rules are different for variable annuities. Since variable annuity payments fluctuate in value, it is impossible to estimate the expected return at the starting date of the annuity. Typically, the excludable portion is determined by dividing the investment in the contract by the number of years over which it is anticipated the annuity will be paid. This calculation may vary depending on the annuitization option chosen.

Tip:  All deferred annuity contracts issued by the same insurance company to the same policyholder during any calendar year are treated as one annuity contract.

Section 1035 Exchanges and Partial Exchanges

In general, under IRC Section 1035, as a Dow Incorporated employee and annuity holder, you can exchange one annuity for another without the immediate recognition of any gain or loss. The exchange can be a complete exchange of one policy for another, or a partial exchange involving the direct transfer of a portion of funds invested in an existing annuity contract to a new annuity contract. However, to obtain this favorable tax treatment, the exchange must satisfy the requirements for a Section 1035 exchange.

Caution:  The rules governing 1035 exchanges are complex and you may incur surrender charges from your 'old' annuity. In addition, you may be subject to new sales and surrender charges for the new policy.

Income Taxation When Gifting an Annuity

There are two ways for an annuity owner to make a gift of an annuity to another individual:

  • The annuity holder can surrender the annuity and give the cash to the individual. However, this method of gifting an annuity will result in the annuity owner being subject to income tax on the untaxed earnings (the cash surrender value of the contract minus the net investment in the contract). In addition, surrendering the annuity and giving away the cash deprives the individual receiving the gift of the ability to continue accumulating tax-deferred interest within the annuity. For Dow Incorporated employees who are considering gifting an annuity, you may want to explore other options than surrender given the income tax and inability to accrue tax-deferred interest.
  • The annuity owner can transfer ownership of the annuity contract to the individual. After the transfer, the annuity contract will continue to exist, with the individual receiving the annuity as the new owner. However, this method of gifting an annuity also generally has immediate tax implications for the transferor. If the transfer involves an annuity contract that was issued after April 22, 1987, the transferor of the annuity is treated as having received income equal to the difference between the cash surrender value of the contract at the time of the gift and his or her net investment in the contract. For those employed at Dow Incorporated, you `may want to take this information into account when choosing between transferring means for an annuity.

Example(s):  Mr. Smith wishes to make a gift of an annuity to his daughter Alexandra. Mr. Smith purchased the annuity contract after April 22, 1987. He has paid $12,000 in premiums into the annuity, and the annuity has a cash surrender value of $20,000. When he gifts the annuity to his daughter, Mr. Smith will recognize taxable income of $8,000.  The tax rules for a transfer involving an annuity issued before April 23, 1987, are a bit more complicated. The transferor of the annuity is taxed on any gains from the annuity in the year the contract was surrendered by the individual receiving the gift, not in the year when the gift was actually made.

Example(s):  Mr. Smith wishes to make a gift of an annuity to his daughter Alexandra. Mr. Smith purchased the annuity contract before April 23, 1987. He has paid $12,000 in premiums into the annuity, and the annuity has a cash surrender value of $20,000. Mr. Smith gifts the annuity to his daughter when she reaches age 21. Alexandra does not surrender the annuity until she reaches age 25. Mr. Smith would not be taxed on the gains from the annuity ($20,000 cash surrender value minus $12,000 in premiums paid into the annuity) until the year the annuity was surrendered--four years after he made the gift of the annuity to his daughter.

Natural Person Requirement

Prior to 1986, the earnings within an annuity were tax deferred regardless of whether the owner of the annuity was a natural person. In 1986, Congress enacted legislation that, among other things, prevented corporations and certain entities from benefiting from the tax-deferred treatment granted to annuities. If a contribution is made to an annuity after February 28, 1986 that is owned by a corporation or other entity that is not considered to be a natural person, the earnings each year on the funds within the annuity are generally included in the owner's taxable income. Despite that, the non-natural person rule does not apply when an annuity contract is held by a trust, corporation, or other non-natural person as an agent for a natural person. In other words, the contract will be treated as an annuity, and the earnings within the annuity will be tax deferred. In addition, it is important for those employed with Dow Incorporated to keep in mind that the non-natural person rule does not apply to certain types of annuities, including any that are:

  • Acquired by a person's estate at the person's death
  • Held under a qualified retirement plan, a tax-sheltered annuity (TSA), or an individual retirement account
  • Purchased by a Dow Incorporated-sponsored plan upon the termination of a qualified retirement plan or TSA program and held by Dow Incorporated until all amounts under the contract are distributed to the employee for whom the contract was purchased (or his or her beneficiary)
  • An immediate annuity (i.e., an annuity purchased with a single premium that begins payments within a year of the date of the purchase of the annuity and provides for a series of substantially equal periodic payments, to be made not less frequently than annually, during the annuity period)
  • A qualified funding asset (i.e., an annuity contract issued by a licensed insurance company that is purchased to fund payments for damages that result from personal physical injury or sickness)

Estate Taxation of Annuities

Generally, the value of an annuity contract is includable in the deceased policyowner's gross estate. If the annuity holder dies before payments begin under the contract, the value of the annuity is equal to the accumulated cash value. If payments have begun at the time of the annuity holder's death, it is the value of the remaining payments, if any, under the contract. If the annuity is owned jointly by individuals who are not married, then the value included in the gross estate is based on each owner's respective contributions. As a Dow Incorporated employee possibly owning an annuity, you may want to consider this information when conducting future planning and ensuring that your assets go to the designated people upon death.

Example(s):  Bill paid 60 percent of the premiums on an annuity, while his cousin Ed paid the other 40 percent. When Bill dies, only 60 percent of the value of the annuity will be included in his gross estate, since he contributed 60 percent of the premiums. When Ed dies, 40 percent of the value will be included in his gross estate.

If the joint owners are married, then half of the value is included in each spouse's gross estate.

Example(s):  Bill paid 60 percent of the premium on an annuity, and his wife, Cindy, paid the other 40 percent. When Bill dies, only 50 percent of the value of the contract will be included in his gross estate, even though he contributed 60 percent of the premiums. When Cindy dies, 50 percent of the value will be included in her gross estate even though she only contributed 40 percent of the premiums.

Example(s):  However, if an annuity contract is gifted to another person by the decedent prior to death and the decedent did not retain any interest in either the contract or the annuitization payments, the value of the annuity contract generally will not be included in the decedent's estate.

Gift Taxation of Annuities Gifted After the Annuitization Starting Date

As a Dow Incorporated employee, if you gift an annuity you may have to pay federal gift tax on the value of the gift. If an individual purchases an annuity and then immediately gifts the annuity to another individual, the value of the gift is considered to be the cost of the annuity contract. If the purchaser of the annuity contract holds the contract for a period of time before gifting it to another individual, and additional payments are required to keep the contract in place, determining the value of the gift is a bit more complicated. The value of the gift is equal to the sum of the interpolated terminal reserve value and the proportionate part of the most recent premium payment that covers the period extending beyond the date of death.

Tip:  The  annual gift tax exclusion  may apply.

How does The Dow Chemical Company’s pension plan structure impact an employee's retirement benefits when considering different retirement ages? The Dow Chemical Company offers various options in its pension plan, and understanding these can significantly affect financial planning for retirement. An employee must weigh the benefits of retiring earlier with potentially lower monthly payments against the advantages of working longer and how this aligns with personal retirement goals and expectations.

The Dow Chemical Company’s pension plan and retirement ages: The Dow Chemical Company’s pension plan structure impacts employees' retirement benefits based on their retirement age. Retiring earlier results in lower monthly payments due to reduced service time and potential early commencement penalties, while working longer allows for more service accrual and higher monthly benefits. Employees must evaluate how these factors align with personal retirement goals, as choosing to retire early might not provide as much financial security as delaying retirement​(The Dow Chemical Compan…).

What are the implications of the 20% mandatory withholding tax on lump-sum distributions from The Dow Chemical Company's pension plan, and how does the option to roll over affect an employee’s tax situation? Employees taking lump-sum distributions need to be cautious about this withholding rule as it can impact their immediate financial needs. Additionally, the rollover option provides a strategy to defer taxes, which can be crucial for long-term financial health. Employees should consider how to best utilize these rules in their personal financial planning.

20% mandatory withholding tax on lump-sum distributions: Lump-sum distributions from The Dow Chemical Company’s pension plan are subject to a 20% mandatory withholding tax if not directly rolled over into another qualified retirement plan. This tax can significantly impact an employee's immediate finances. However, opting to roll over the lump sum to a qualified plan defers taxation until funds are withdrawn, allowing employees to manage their tax liabilities better while continuing to grow their retirement savings​(The Dow Chemical Compan…).

How does The Dow Chemical Company ensure that employees understand their eligibility for retirement benefits based on various service and age criteria? Eligibility considerations based on service years and age can significantly influence the retirement timeline for employees. Moreover, it’s essential for employees to be well-informed about these factors to make educated decisions pertaining to their retirement and whether adjustments to their career plans are needed for maximizing benefits.

Eligibility for retirement benefits: The Dow Chemical Company outlines eligibility for pension benefits based on a combination of service years and age. Typically, employees become vested after three years of service or upon reaching age 65 while still employed. The company ensures that employees are informed about these eligibility criteria through various resources, such as the Dow Benefits Service Center, enabling them to make informed retirement decisions​(The Dow Chemical Compan…).

In what ways can employees of The Dow Chemical Company appeal decisions regarding their pension benefits, and what processes are in place to facilitate these appeals? The appeal process is critical for employees who might feel that their benefits have not been administered correctly. Understanding the correct procedures and having access to the right resources can empower employees to effectively advocate for themselves in the face of administrative decisions.

Appealing pension benefit decisions: If employees believe there has been an error in the administration of their pension benefits, The Dow Chemical Company provides a formal appeal process. Employees can file a claim, and if denied, they have the right to appeal the decision. The Retirement Board oversees these appeals, and employees must follow the outlined procedures for their appeal to be considered​(The Dow Chemical Compan…).

What strategies can employees of The Dow Chemical Company employ to maximize their pension benefits while transitioning to retirement? Employees must navigate complexities such as contribution limits, benefit formulas, and personal retirement savings. A strategic approach, which includes understanding the timing of retirement and how it interacts with pension claims, can lead to more favorable financial outcomes in their retirement years.

Maximizing pension benefits: Employees at The Dow Chemical Company can maximize their pension benefits by carefully planning their retirement timing. Key strategies include working longer to accrue more service years, reviewing contribution limits, and understanding the benefit formula used. Aligning personal savings and pension claims with the optimal retirement age can result in more favorable financial outcomes​(The Dow Chemical Compan…).

How can retirees from The Dow Chemical Company navigate survivor benefits, and what are the eligibility criteria for spouses or domestic partners? Survivor benefits are an essential aspect of retirement planning, especially for employees concerned about providing for their loved ones after death. It’s vital for employees to understand both eligibility and what benefits their partners might receive, fostering peace of mind during retirement planning endeavors.

Survivor benefits for retirees: Retirees from The Dow Chemical Company can opt for survivor benefits to provide financial security for their spouses or domestic partners. Eligibility for these benefits depends on the plan's structure, and employees should understand the options available to ensure their loved ones are covered after their death. These benefits include continued monthly payments or lump-sum options depending on the election made at retirement​(The Dow Chemical Compan…).

How does The Dow Chemical Company’s defined benefit pension plan differ from other retirement plans, and what should employees know when comparing their options? Employees need to understand the distinctions between defined benefit plans and other types such as defined contribution plans for effective retirement planning. This understanding will help them better appreciate the benefits and risks associated with their choices and aid with decision-making processes.

Comparing defined benefit pension plan: The Dow Chemical Company offers a defined benefit pension plan, which differs from defined contribution plans like 401(k)s. In a defined benefit plan, the company guarantees a specific monthly benefit upon retirement, typically based on years of service and salary, whereas defined contribution plans depend on employee contributions and investment performance​(The Dow Chemical Compan…).

What resources does The Dow Chemical Company provide to employees seeking detailed information about their retirement options, and how can they effectively utilize these? Accessing the right resources can bridge knowledge gaps regarding pension plans. Employees should know about dedicated pathways to assistance, such as benefit service centers and consultation avenues, to fully leverage their benefits package.

Resources for retirement information: The Dow Chemical Company provides several resources for employees to access detailed information about their retirement options. The Dow Benefits Service Center and My HR Connection are key tools where employees can request pension estimates, understand payment options, and clarify eligibility criteria. These resources help employees make informed decisions regarding their retirement planning​(The Dow Chemical Compan…).

With changes in IRS rules becoming increasingly relevant, how do employees of The Dow Chemical Company stay informed about updates that may impact their retirement savings? Employees need to be active participants in their retirement planning by staying abreast of legal and regulatory changes that can influence their financial strategies. Having a clear understanding of these regulations can help ensure compliance while maximizing possible financial benefits under updated laws.

Staying informed about IRS rules: Employees of The Dow Chemical Company must stay informed about IRS rules that may affect their retirement savings. Changes in tax laws, contribution limits, or distribution rules can significantly impact financial planning. The company provides updates and resources to ensure employees are aware of relevant regulatory changes that might affect their retirement strategies​(The Dow Chemical Compan…).

How can employees of The Dow Chemical Company reach the benefits service center for additional inquiries regarding their pension plan, and what information should they prepare beforehand? Knowing how to contact the benefits service center is crucial for employees seeking clarity on their pension plan benefits. Preparing relevant information ahead of time can streamline the process, allowing for a more productive engagement with benefits specialists and ensuring that employees receive precise guidance tailored to their situations.

Contacting the benefits service center: Employees seeking clarification about their pension benefits can reach the Dow Benefits Service Center via phone or online through the Message Center. It is recommended to have personal identification and details of the pension plan ready to streamline the inquiry process. Proper preparation ensures a productive conversation with benefits specialists​(The Dow Chemical Compan…).