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 Sears Holdings 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accumulate income-tax deferred, and the annuity owner will not be subject to income tax on such earnings until they are withdrawn.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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings, 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 Sears Holdings 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 Sears Holdings-sponsored plan upon the termination of a qualified retirement plan or TSA program and held by Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings Pension Plan differentiate between normal retirement, early retirement, and late retirement options for Kmart participants? In what ways do these options influence the retirement planning process for employees of Sears Holdings, and what specific considerations should Kmart employees be aware of when choosing one of these retirement paths, particularly in relation to their vested status?
Differentiation of Retirement Options: The Sears Holdings Pension Plan offers distinct options for normal, early, and late retirement. Normal retirement is available at age 65 or after five years of plan participation, whichever is later. Early retirement can be taken from age 55 but before 65, provided the employee is vested, with benefits subject to actuarial reduction unless certain conditions are met (like having at least 90 points, which is a sum of age and years of credited service). Late retirement pertains to any retirement after the normal retirement age, with pensions recalculated to reflect the delay in benefit commencement.
Considering the frozen status of the Sears Holdings Pension Plan, how does this impact the benefits eligibility for Kmart employees, and what implications does it have for their retirement savings strategies? In what ways should current employees factor in this frozen status when evaluating their overall retirement readiness and potential alternatives outside of the company plan?
Impact of Frozen Status: The freezing of the Sears Holdings Pension Plan on January 31, 1996, means that there have been no new accruals of benefits or participants since that date. For Kmart employees, this impacts their benefits eligibility by capping the pension benefits at levels earned up to the freeze date. Employees need to consider this stagnation in benefits when planning for retirement, potentially seeking additional retirement savings avenues to bridge any shortfall.
What are the essential calculations involved in determining the retirement benefits under the Sears Holdings Pension Plan for Kmart employees? Specifically, how do the Career Average Pay and Final Average Pay formulas come into play, and what factors should employees consider when estimating their future retirement payouts?
Essential Calculations for Retirement Benefits: Pension benefits for Kmart employees under the Sears Holdings Pension Plan are calculated using either the Career Average Pay or the Final Average Pay formulas. These calculations take into account an employee's years of credited service and compensation up to the freeze date. Factors like estimated Social Security benefits and specific formulas (such as a deduction based on Social Security benefits under the Final Average Pay formula) play crucial roles in determining the final pension payout.
How can Sears Holdings employees best navigate the process of applying for benefits under the Pension Plan? What specific steps should participants take to ensure their applications are processed correctly, and what important deadlines should they be aware of to avoid any negative consequences on their retirement benefits?
Navigating the Benefits Application Process: To apply for pension benefits, employees must submit a formal application, ideally 30 to 90 days before the intended commencement date. It is crucial to ensure all personal information, including marital status and spouse details, is up-to-date to avoid delays or inaccuracies in benefit processing. Missing application deadlines can lead to postponed benefit payments or unwanted default options.
In what situations can Kmart employees expect to receive a Deferred Vested Pension, and how is the calculation for this pension affected by their previous employment and vesting service? Employees should be aware of the important factors influencing their eligibility and the steps necessary to maintain their retirement benefits after leaving the company.
Eligibility and Calculation for Deferred Vested Pension: A Deferred Vested Pension is available to employees who leave the company after becoming vested but prior to qualifying for retirement. The calculation mirrors that of a normal retirement pension, with possible early commencement reductions. Understanding the timing of benefit commencement and the potential reductions for early start is vital for planning.
How does the Sears Holdings Pension Plan address tax considerations for employees receiving both monthly payments and lump sum payments upon retirement? What tax implications should Kmart participants be aware of, particularly in relation to IRS rules for distributions and potential penalties for early withdrawal?
Tax Implications of Pension Receipt: Pension payments, whether monthly or lump sum, are subject to federal taxes. Monthly benefits are taxed as ordinary income, while lump sums might be eligible for special tax treatments or rollover options to defer taxes. It’s important for Kmart employees to consider these implications and possibly consult with a tax advisor to optimize tax liability.
What are the rights and protections afforded to Kmart participants under the Employee Retirement Income Security Act (ERISA) as they navigate their retirement benefits with the Sears Holdings Pension Plan? How can employees leverage these rights to ensure they are receiving all the benefits to which they are entitled?
ERISA Rights and Protections: Under ERISA, Kmart employees are entitled to certain rights including the ability to appeal denied benefits, access to plan information, and assurances of fair and equitable treatment of their benefits. Leveraging these protections ensures that employees receive all due benefits.
What steps should Kmart employees take to update their personal information to ensure they continue receiving their benefits without interruption, especially in the context of missing participants or uncashed checks? What resources and contacts at Sears Holdings are available to assist with these updates?
Updating Personal Information: Maintaining accurate personal information with the pension plan is crucial for uninterrupted benefit payments. Employees should promptly update changes such as address, marital status, or beneficiaries to prevent issues with benefit distributions or lost checks.
How does the process of transferring between affiliated employers impact pension benefits for Kmart employees under the Sears Holdings Pension Plan? What considerations should be taken into account concerning Credited Service and Vesting Service during such transfers, and how can employees ensure they do not lose any entitled benefits?
Impact of Transfers Between Affiliated Employers: Transferring between Sears Holdings’ affiliated employers can affect pension benefits differently depending on whether the employer participates in the pension plan. It's essential to understand how such transfers impact credited and vesting service accruals.
For Kmart employees seeking more information about their benefits under the Sears Holdings Pension Plan, what is the best way to contact company representatives? How can they effectively communicate their questions or concerns to ensure they receive accurate and timely information regarding their retirement benefits?
Contacting Plan Representatives: Kmart employees seeking clarity on their pension benefits should contact the Sears Holdings Pension Service Center. Effective communication, including prepared questions and necessary documentation, will aid in obtaining accurate and comprehensive information.