Just the words “United States Internal Revenue Tax Code” have some people reaching for an antacid and a glass of water. A task even more daunting is trying to figure out inheritance issues relating to annuities. This is what Section 72(s) refers to, annuity payouts that must be distributed because the owner has died but the full interest has not been distributed. Breaking the code down into smaller bits will help to understand the finer points.
Before getting into the true meaning behind Section 72(s), some definitions of the terms used are in order. The designated beneficiary is a person who has been specifically named as the benefactor of the contract. For example, if you start a life insurance policy and name your child as the recipient of the payout upon your death, your child is the designated beneficiary. Annuities are contracts between an individual and an insurance company to earn money through interest and have a guaranteed income later in life. Annuities are tax deferred until the money is withdrawn or is used as a monthly income. Section 72(s) deals exactly with what happens when the holder dies before the disbursements have begun.
If the holder of the annuity dies before the annuity start date, the interest shall be distributed within five years after the death of the holder. If the holder dies on or after the annuity start date, the methods of distribution will be carried out as originally outlined, if not faster. If the holder has a surviving spouse and this spouse is the designated beneficiary, the annuity can be continued through, this is called a Spousal Continuance. When the new owner dies, then distributions will be dispersed to the remaining beneficiaries.
If the beneficiary is a trust or charity (or any non-entity), it will fall under the five-year rule, which states that the contract must be fully distributed within five years. This will cause a heavy tax burden upon the entity receiving the funds. A lump sum payment would most definitely be taxed heavily and this falls under the five-year rule as a viable option. Most tax advisors would suggest the one-year rule as a way of receiving the interest income. One way for the beneficiary to qualify for the one-year rule is through life expentancy. The distribution must begin less than one year after the contract holder’s death throughout the beneficiary’s life expectancy. This way, most of the tax is still deferred throughout the distribution of the interest income.
Section 72(s) is just about how to handle the distribution of funds from an annuity contract after the contract holder has passed away, it just takes a lot of language to make sure all of the bases are covered. Now that the language has been broken down a bit further, it is much easier for the layperson to understand. As with any financial situation, however, it is best to further consult with a professional regarding any decisions to be made for estate planning or investments. However, with this information, you will have a better understand to what these professionals are discussing with you.
