LIFE INSURANCE AND ANNUITIES
PART A: LIFE INSURANCE
The insurance proceeds paid to Andrew are tax-free under § 101(a)(1), the general rule
providing that gross income does not include amounts received under a life insurance contract by
reason of the death of the insured. (We assume throughout this problem set that the insurance
policies referred to constitute life insurance contracts.) The fact that Andrew uses the proceeds to
prepay the mortgage is irrelevant for § 101(a)(1) purposes.
The alternative question asks what result if the proceeds are payable to the mortgagee who
happens to be the bank which lent Paula the money to purchase the home. Assume for a moment
that the mortgagee had purchased the policy on Paula's life, naming itself beneficiary and paying the
premiums. In similar circumstances, Rev. Rul. 70-254, 1970-1 C.B. 31, cited in the Overview, holds
that amounts received by the creditor on the death of the insured are not payable "by reason of the
death of the insured" and are thus not within § 101(a)(1) but are instead collections of the unpaid
balance. In our problem, it appears that Paula owns the policy and pays the premiums. We assume,
however, that the proceeds the mortgagee receives must be applied to the unpaid mortgage.
Logically, in such a case, the Service would apply the policy of Rev. Rul. 70-254 and regard the life
insurance proceeds as a collection of the unpaid balance on the mortgage rather than a § 101(a)(1)
exclusion. The benefit derived by Andrew as a result of the payment of the mortgage balance should
be excludable - in effect Paula has devised the home to Andrew free of encumbrance. See § 102.
The insurance proceeds Mary receives are all excluded under § 101(a)(1). Note that the
$40,000 Mary receives actually consists of: (1) a return of the "extra" $12,000 in premiums Rick
paid for a whole or ordinary life insurance rather than term insurance; (2) payment of $2,000 in
earnings on the premiums, i.e., the difference between the $12,000 excess over the term insurance
cost and the $14,000 cash surrender value; (3) a return of the $6,000 term insurance premiums paid;
and (4) a net mortality gain of $20,000. Payments under a term insurance policy and payments under
a whole life policy are both tax-free. The whole life policy, however, includes a tax-free interest
element (here, $2,000) not present in a term policy. The term policy would have a $34,000 net
mortality gain, along with a $6,000 return of premiums.
Only $40,000 of the $47,500 payment will be excluded under § 101(a)(1). Whether analyzed
under § 101(c) or § 101(d), the remaining $7,500 is in the nature of interest and will be included in
gross income. Section 101(d)(3) notes that § 101(d) shall not apply to any amount to which § 101(c)
This raises a § 101(a)(2) transfer-for-value issue. Under the general rule of § 101(a)(2) - its
first sentence - the payment of $250,000 on John's death would be tax-free only to the extent of the
purchase price of $60,000 plus premium payments made by John subsequent to the transfer.
However, under § 101(a)(2)(B), a transfer to the insured is not subject to the transfer-for-value rule.
Thus, since the transfer is to John, the insured, the rule of § 101(a)(1) applies to the life insurance
proceeds, and all $250,000 is excluded from gross income.
If the corporation transfers the policy to Philip, John's son, the § 101(a)(2)(B) exception is
unavailable. Philip will be taxed on the $250,000 he receives, less the aggregate of the $60,000
purchase price and subsequent premiums paid by Philip. Since Philip receives the insurance
proceeds under either approach, it obviously makes sense to have John purchase the policy rather
(For discussions of the amount of income and character of income on surrender, sale and
secondary sale of life insurance contracts, see Rev. Rul. 2009-13 and Rev. Rul 2009-14 in 2009-21
I.R.B. 1029 and 1031, respectively.)
PART B: ANNUITIES
George has purchased an annuity from the life insurance company. George's investment is
$5,000 and George is going to receive a total of $10,000 over the next 10 years. George will thus
receive a $5,000 return on the investment he made. When will George report this $5,000 return on
his investment? May George simply recover his $5,000 investment first? That is, will the first
$5,000 received by George from the company be tax free, or will George be required to report a part
of each payment as income?
Section 72 is the applicable provision. The general rule of § 72(a) provides that amounts
received as an annuity will be treated as gross income. However, § 72(b) provides an exclusion
ratio, i.e., gross income does not include that part of any amount received as an annuity which bears
the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears
to the expected return under the contract (as of such date).
Section 72(c)(1) defines "investment in the contract." Essentially that phrase means the
amount of premiums paid for the contract, less any amount received under the contract before such
date to the extent that it was excludable from gross income. Here, the investment in the contract is
Section 72(c)(3) defines "expected return." When the annuity does not depend on life
expectancy, the "expected return" is the amount receivable under the contract. In this case, the
amount receivable is $10,000, and that is the expected return.
Thus, 5,000/10,000, or ½, or 50% of each payment constitutes a return of capital and is not
taxed; the balance of each payment is income. This timing arrangement permits a spreading of the
income over time. As the students will learn in Chapter 41, the treatment of annuities under § 72
is essentially the same as the treatment that is accorded taxpayers selling property under the
Now Friendly agrees to pay George $1,000 per year for life. George's investment in the
contract is $10,000. The expected return will be determined under § 72(c)(3)(A) by referring to
actuarial tables which provide the applicable multiple. See Reg. § 1.72-5(a)(1): "If a contract to
which section 72 applies provides that one annuitant is to receive a fixed monthly income for life,
the expected return is determined by multiplying the total of the annuity payments to be received
annually by the multiple shown in Table I or V (whichever is applicable) of Section 1.72-9 under the
age (as of the annuity starting date) . . . of the measuring life. . . . " After June 30, 1986, one uses
Table V. In this case, the multiple (from Table V) is 28.6; the expected return is $28,600. The
exclusion ratio is therefore 10,000/28,600. Thus, 100/286 or approximately 35% of each payment
will be excluded as a return of capital, with the balance being reported as income.
If George dies after receiving only three payments, § 72(b)(3) provides that the amount of
the unrecovered investment shall be allowed as a deduction to the annuitant for his last taxable year.
Note the definition of "unrecovered investment" in § 72(b)(4) --it is "the investment in the contract
as of the annuity starting date, reduced by the aggregate amount received under the contract on or
after such annuity starting date and before the date as of which the determination is being made, to
the extent such amount was excludable from gross income under this subtitle."
In this problem, George would have recovered approximately $1,050 [.35($1,000) x 3]. On
George's final tax return, a deduction of $8,950 should be claimed. Note that this deduction is not
subject to the 2% floor of § 67. I.R.C. § 67(b)(10).
If George is still living 30 years from now, the next $1,000 will be 100% taxable. There will
be no exclusion because George will have recovered his entire investment over the first 29 years.
Section 72(b)(2) provides that "the portion of any amount received as an annuity which is excluded
from gross income under paragraph (1) shall not exceed the unrecovered investment in the contract
immediately before the receipt of such amount."
This is a joint and survivor annuity. Reg. § 1.72-5(b)(1) provides "in the case of a joint and
survivor annuity contract involving two annuitants which provides the first annuitant with a fixed
monthly income for life and, after the death of the first annuitant, provides an identical monthly
income for life to a second annuitant, the expected return shall be determined by multiplying the total
amount of the payments to be received annually by the multiple obtained from Table II or VI." After
June 30, 1986, one uses Table VI. In this case, 33.6 is the appropriate multiple. The expected return
would be $33,600, i.e., $1,000 x 33.6.
The investment in the contract is $15,000. The exclusion ratio is therefore 15,000/33,600.
Approximately 44.6% of each $1,000 payment, or $446, will be excludable and the balance will be
included in income.
PART C: INDIVIDUAL RETIREMENT ACCOUNTS
Assume a joint return for 2010, and ignore inflation adjustments to the various dollar limits.
(a) Deductible IRA. For Ron, the potential $6,000 deduction ( $5,000 under § 219(b)(5)(A)
and, because he is over 50, a $1,000 addition in the deductible amount under § 219(b)(5)(B)) is
phased out to zero because of the adjusted gross income level and active participation in a pension
plan. § 219(g)(1), (2) and 3(B)(i). For Mary, there is a $2,500 deduction. She is not over 50, so her
potential deductible amount is $5,000. She is not an active participant and the applicable dollar
amount for her is $150,000. § 219 (g)(7). With an adjusted gross income that is $5,000 greater, her
deduction is reduced by 5/10 or 50%. Thus, she is entitled to a $2,500 deduction. I.R.C.
(b) Nondeductible IRA. Ron can contribute up to $6,000 because he is over 50. Mary’s
limit is $5,000. See §§ 219(b)(5), 408(o)(2).
(c) Roth IRA. With an adjusted gross income of $155,000, and an applicable dollar amount
of $150,000 (I.R.C. § 408A(c)(3)(B)(ii)(I)), the reduction in the dollar limit on a joint return is the
ratio formed by $5,000 over $10,000. As a result, the Roth limits are cut by 50%; thus, Ron’s limit
is $3,000, and Mary’s limit is $2,500. I.R.C. §408A(c)(3)(A).
(1) Distribution from Roth IRA: If the $20,000 distribution is a qualified distribution
from a Roth IRA, it is excluded from gross income. § 408A(d)(1). That exclusion is at the heart of
the Roth IRA. To be a qualified distribution, the $20,000 distribution must satisfy the definitional
requirements at § 408A(d)(2).
(2) Distribution from a Deductible IRA: If, alternatively, the $20,000 distribution is from
a deductible IRA, the distribution will be taxable in its entirety. To begin with, note that § 408(d)(2)
provides that for distribution purposes all IRAs will be treated as a single IRA, that all distributions
during the year will be treated as a single distribution and that account balances must be computed
as of years’s end, augmented by distributions during the year. In our case, this is Grace’s only IRA
and her only distribution. Under § 408(d)(1), the distribution is included in income in the manner
provided under § 72. Under § 72, the distribution is included in income, except to the extent it is
treated as a return of the taxpayer’s investment in the contract or basis. § 72(a), (b)(1), (e). Since
the taxpayer’s contributions were fully deductible, her basis in the IRA, or her investment in the
contract, is appropriately zero, and the full $20,000 must be included in income. See, for example,
Reg. § 1.408-4(a). (This distribution is in the nature of an “amount not received as an annuity” under
§ 72(e), rather than an “amount received as an annuity” under § 72(a). In either case, the zero basis
means the amount is fully taxable.)
(3) Distribution from a Nondeductible IRA: Here the $20,000 distribution is from a
nondeductible IRA, where the nondeductible contributions total $60,000 and the account balance
at the end of the year is $80,000. As a result, 60% of the distribution - i.e., $60,000 divided by
$100,000, where the $100,000 represents the total of the $80,000 balance and the $20,000
distribution - will be treated as a return of the taxpayer’s investment in the contract and excluded
from income. Accordingly, Grace will include the remaining 40% of the distribution, or $8,000, in
gross income. Her remaining basis in the IRA will now be $48,000, reflecting the $12,000 portion
of the distribution that was treated as nontaxable. See §§ 408(d), 72(a), (b), (e). [Note: This has been
an abbreviated calculation of the taxable and nontaxable portions of the $20,000 distribution. As
spelled out in Notice 87-16 and Publication 590, cited above, this calculation must take into account,
inter alia, the value of all IRAs as of the end of the year, plus any outstanding rollovers. As noted
previously, all IRAs are to be treated as a single IRA and all distributions during the year are to be
treated as a single distribution. The formula for determining the nontaxable portion of the
distribution is to multiply the distribution amount - the sum of all distributions during the year (here
$20,000) - by a fraction. The numerator of the fraction is the taxpayer’s investment in the contract
(basis), which consists of the total nondeductible contributions in all the taxpayer’s IRAs (here
$60,000), but not including any nondeductible contributions previously treated as withdrawn (here,
$0). The denominator of the fraction is the fair market value at year’s end of all the taxpayer’s IRAs
(here, $80,000), increased by the distribution amount (here, $20,000) and by any outstanding
rollovers (here, $0). The result in our case is an exclusion ratio of 60%, applied to the $20,000
If the distribution is a nonqualified distribution from a Roth IRA, the distribution in this case
is still nontaxable. Under § 408A(d)(4)(B), the distribution is to be treated as made from
contributions to the Roth IRA to the extent thereof (reduced by any previous distributions). Since
contributions to a Roth IRA are nondeductible, and since Grace’s contributions here were $60,000,
the entire $20,000 distribution is treated as a return of her contribution and hence as a nontaxable
return of basis, or return of her investment in the contract, under the principles of § 72. Such an
ordering rule, which treats a distribution as consisting first of a return of contributions, is obviously
more favorable than a rule prorating the distribution between a nontaxable return of basis and a
taxable distribution of earnings.
The early distribution penalty of § 72(t)(1) is equal to 10% “of the portion of [the
distribution] which is includable in gross income.” With respect to the distribution from the
deductible IRA, the amount includable in gross income is the full $20,000, so the § 72(t) penalty
would be $2,000 (separate and apart from whatever tax liability results from the inclusion of the
$20,000 in income). With respect to the nondeductible IRA, the $20,000 distribution was includable
in income in the amount of $8,000 so the § 72(t) penalty would amount to $800. (It might be noted
that nonqualified distributions from a Roth IRA are also subject to the penalty tax, unless one of the
exceptions apply. In our problem, since no part of the nonqualified distribution constituted gross
income, there would be no § 72(t) penalty.