Could beneficiaries subtract federally taxable lump-sum death benefits received from annuity contracts on their Virginia income-tax return?

Subject

Federally taxable lump-sum annuity death benefits qualified for subtraction

Plain-English summary

Virginia allowed the beneficiaries to subtract the federally taxable portions of two lump-sum annuity death benefits. The ruling identified three requirements: the payment had to come from an annuity contract between an annuitant and an insurance company, be awarded to the beneficiary in a lump sum, and be subject to federal income tax.

Both payments met those requirements. One contract had already entered its payout period before the annuitant died; the other had not yet matured. In each case, the beneficiary received annuity death proceeds, chose or received a lump-sum distribution, and reported a federally taxable amount.

The ruling explained that an annuity beneficiary generally excludes the investment portion but pays federal tax on earnings above that amount. Virginia's subtraction, effective for taxable years beginning on or after January 1, 2007 under the cited law, applied to the death-benefit amount subject to federal taxation.

What this means for you

• Confirm that the payment is legally an annuity death benefit, not merely a distribution associated with a deceased owner.
• Keep the contract, beneficiary designation, payout election, Form 1099-R or equivalent tax reporting, and federal return support.
• The ruling required lump-sum payment and federal taxation under the provision then in effect.
• Verify current Virginia law before claiming the subtraction.

Common questions

Did the full gross distribution qualify?

The ruling described the subtraction by reference to the death-benefit payment subject to federal taxation.

Did it matter that the two annuities were at different contract stages?

No. Both satisfied the three stated requirements despite one being in payout and the other being pre-maturity.

Why was the subtraction available?

Virginia said the statute was intended to reduce the different tax treatment between taxable annuity death benefits and generally tax-exempt life-insurance death benefits.

Citations and references

• Va. Code § 58.1-322(C)(32).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-36

Original ruling text

March 31, 2009

Re: Ruling Request: Subtraction for Death Benefit Payments from an Annuity

Dear *:

This is in response to your letter of March 28, 2008, in which you requested a ruling regarding whether the death benefit payments from an annuity contract are eligible to be subtracted under Va. Code § 58.1-322 on behalf of * (the "Taxpayers"). I apologize for the delay in this response.

FACTS

One of the Taxpayers (the "Beneficiary") has received death benefits from two separate annuities (the "Annuities") following the death of * (the "Annuitant") in 2007. The first annuity was purchased for . The gross distribution from this annuity in 2007 was , with a taxable amount of . The second annuity was purchased for . The gross distribution from this annuity to the Beneficiary in 2007 was with a taxable amount of **. Based on the information provided, the death benefit payments from the Annuities were reported for federal income tax purposes; and the interest earned from the initial investments was subjected to federal income taxation.

The first annuity contract was issued on September 9, 1994, and had an annuity date of March 18, 2004, whereby the Annuitant would begin receiving the benefits of her investment. In this case, the Annuitant's death occurred during the annuitant period, or when the proceeds of the contract were being distributed to the Annuitant. Under the terms of this contract, the Beneficiary was able to receive the proceeds upon the death of the Annuitant. The Beneficiary had the option within 60 days after proceeds were payable to receive the payment in a lump sum or according to an annuity payment option.

The second annuity contract was issued on October 13, 1994, with a maturity date of March 18, 2015. Based on the information provided, the Annuitant's death occurred prior to the maturity date of the annuity. Under the terms of the contract, this meant that the company providing the annuity was required to pay to the beneficiary the account value as of the day on which written notice of the death was received by the company. This amount was required to be distributed to the Beneficiary within five years of the death of the Annuitant.

You are writing to inquire whether the Taxpayers' death benefit payments from the above mentioned Annuities are eligible to be subtracted from taxable income pursuant to Va. Code § 58.1-322 C 32.

RULING

Many people use annuity contracts as a retirement planning tool. These contracts allow retirement savings to grow on an income tax-deferred basis and have a wide variety of payout plans to benefit annuitants. In addition, some of these plans will allow for a lump sum distribution to a beneficiary after the death of the annuitant. Unlike insurance contract payments which are generally exempt from federal income tax, payments received from an annuity contract by a beneficiary after the death of an annuitant are only partially tax exempt.

Annuitants may avoid paying tax on a portion of each payment representing the amount invested in the annuity contract, while the rest of each payment is treated as taxable income earned on the investment in the annuity contract. These rules also apply to payments received by a designated beneficiary upon the death of the annuitant. Thus, while a beneficiary will be able to exclude the investment amount, he or she must pay income tax on the excess amount. Because Virginia conforms to the Internal Revenue Code, this amount has been included for Virginia income tax purposes as well.

Pursuant to Va. Code § 58.1-322 C 32 and effective for taxable years beginning on and after January 1, 2007, a taxpayer is allowed a subtraction for death benefit payments received from an annuity contract to the extent that such payments are subject to federal income taxation. It is our understanding that the intent of this law was to equalize the tax treatment of death benefits for those who cannot obtain life insurance because they are uninsurable for health reasons. This is because life insurance benefit payments paid by reason of the death of the insured are exempt from federal taxation, and thus exempt from Virginia taxation, while a portion of the death benefits from an annuity contract are taxable. Thus, those who cannot obtain standard life insurance and so must utilize annuities to provide a similar benefit to their loved ones are treated dissimilarly for tax purposes. It was on this basis that the death benefits subtraction for annuity contracts was created.

Therefore, in order to qualify for the subtraction allowed under Va. Code § 58.1322 C 32, a death benefit payment is required to meet the following criteria: 1) the source of the payment is an annuity contract between a customer (the Annuitant) and an insurance company; 2) it has been awarded to the beneficiary in a lump sum; and 3) the payment is subject to taxation at the federal level.

It is evident from the information provided by the Beneficiary that the death benefit payments in this case satisfy all three of these criteria. The information demonstrates that the payments are derived from an annuity contract between a customer and insurance company, that they were received in a lump sum by the Beneficiary, and that the payments were subject to federal taxation. Therefore, the Taxpayers will be allowed to utilize the Virginia income tax subtraction for death benefits pursuant to Va. Code § 58.1-322 C 32.

I trust that this reply answers your ruling request. The Code of Virginia sections cited and other reference documents are available on-line in the Tax Policy Library section of the Department of Taxation's web site located at www.tax.virginia.gov. If you

should have any questions regarding this ruling, you may contact * in the Office of Policy and Administration, Policy Development, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner