Tax free “Investment Annuity” from 1976: stranger than fiction

[calmaniac]

[2016 thread bumped in 2024 --admin LadyGeek]

My father invested in a “variable investment annuity”, which was a financial vehicle that sprung up briefly in 1976-77, before it was snuffed out by IRS ruling 77-85. The basic features of this investment annuity are that it: 1. allows investment in stocks and or mutual funds; 2. receives a step-up in cost basis upon the death of the owner (tax free). On the surface, pretty awesome, tax free investing in stocks or mutual funds! Investment annuities that were purchased prior to March 10, 1977 were grandfathered in and allowed to continue.

So here is where it gets even stranger. On the death of the owner, beneficiaries can do one of two things: 1. assume the lump sum proceeds at the stepped-up cost basis (tax free); 2. become the new owner (must be born before 1977) and designate a new beneficiary. My father, the current owner, has me as one of the beneficiaries, and in turn when he passes, I would become the owner and could name my children as the beneficiaries. On the face of it, an amazing way to pass on wealth to future generations. I clearly need to check with a lawyer who has an expertise with such annuities.

Questions:
1. Does anyone in the Boglehead continuum have any knowledge or experience with this type of investment annuity?
2. Any problems with this approach?
3. Suggestions for lawyers with an expertise in such?

I’d be grateful for your insights! Thanks

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Here is a letter from the insurance company that runs it explaining the account:

Re: Chesapeake Investment Annuity #XXXXXXXXX

I am providing you with the following information on the above referenced policies.

The Chesapeake investment annuities are single-premium deferred annuities. They were sold before DEFRA and TEFRA became effective. They were issued in 1976 and 1977 before the IRS reversed the rulings governing them. Fortunately, their published Revenue Ruling 77-85 "grandfathered" contracts issued before the cutoff date of March 10, 1977 so long as there were no additional contributions made to them. When a contract is "grandfathered" by the IRS it means that prior, more favorable tax aspects are preserved.

These investment annuities have an ideal combination of contractual and income tax rights. Tax is deferred on the earnings. Withdrawals are first-in, first-out, and any remaining gain on the death of the owner establishes a new income-tax free cost basis to the beneficiary, and all the while each successive owner retains control over the underlying investments. The policy has to be taken as a lump sum settlement or be annuitized by anyone born after March 9, 1977.

This policy receives a step-up in cost basis upon the death of the owner, not the annuitant. This means that the basis to the new owner becomes the fair market value of the contract at the date of death of the previous owner. Most annuities do not qualify for a step-up in cost basis. This investment annuity, however, was afforded this treatment in Revenue Ruling 70-143. Later, Revenue Ruling 79-335 revoked this favorable treatment, but fortunately contracts issued prior to October 21, 1979 were "grandfathered".

Since the right to FIFO withdrawals is also 'grandfathered", the new owner has a tax-free source of income up to the value of the entire account at the date of death of the previous owner. Therefore, once again, until the amount of withdrawals received exceeds the new stepped-up cost basis, all withdrawals will be reported as non-taxable.

The Custodian Account Agreement is an integral part of these investment annuity contracts. The custodian for these accounts is The Lincoln Trust Company. The primary duty of the custodian is to follow the investment instructions of the owner and to provide safekeeping of assets. Any questions regarding account values, fees, or particular funds or stocks held within this policy should be directed to them. You can reach them at 1-800-962-4238. This number connects you to Team K, as they are the team that deals specifically with these policies.

The custodian also collects premiums as specified in the owner's contract. In addition to the annual premium based upon year-end market value, premiums are payable in connection with partial withdrawals, surrenders, or annuity payouts. The annual premium is typically ¼ of 1% of the account value, with a minimum of $100.00 and a maximum of $500.00. State premium taxes are also charged at a rate of 2.35% in California Therefore, a statement for an account of over $200,000.00 will have an entry of $500.00 for premium and $11.75 for premium state tax. The premium on an account value less than $200,000.00 will show less for both premium and state taxes.

[grabiner]

If your terms are correct, the main concern would be whether the fees on the annuity are costing you more than the tax savings. When your father dies, you could cash in the annuity with no tax costs, and invest in a stock index fund. If you do that, you would lose 0.3% per year to taxes (assuming a 2% yield and a 15% tax rate), and your heirs could inherit that stock fund with a stepped-up basis.

So, if the only fees are 0.25% per year (capped at $511.75) and you have low-cost investments such as ETFs, it's a good deal; you pay 0.25% in fees to avoid at least 0.30% in taxes. If the investment options are high-cost stock funds, it isn't.

[calmaniac]

grabiner, thanks for your input and analysis. A straightforward but powerful way to look at it, tax savings vs. fee costs.

My father has enough money in the account that the $511.75 annual fee represents something like 0.04% per annum, so good there. Thanks!

[SteveFord]

Sorry to bring up an old thread but I own an annuity like this. I took the money out and now I have a letter from the IRS. The insurance company was no help because they don't get into taxes this deep they just give you a 1099 and let you deal with the IRS.

Does anybody know a good tax attorney that is familiar with these types of annuities that can help ?

Thanks!

[calmaniac]

Does anybody know a good tax attorney that is familiar with these types of annuities that can help ?

Thanks!

Steve,

I am the OP on this thread. I found one tax attorney who had experience with these, URL below. Feel free to message me if you have additional questions. I have a number of written materials on these types of accounts and am happy to share.

https://www.venable.com/professionals/c/carol-v-calhoun

[Stinky]

Sorry to bring up an old thread but I own an annuity like this. I took the money out and now I have a letter from the IRS. The insurance company was no help because they don't get into taxes this deep they just give you a 1099 and let you deal with the IRS.

Does anybody know a good tax attorney that is familiar with these types of annuities that can help ?

Thanks!

SteveFord, welcome to the Forum!

grabiner, thanks for your input and analysis. A straightforward but powerful way to look at it, tax savings vs. fee costs.

My father has enough money in the account that the $511.75 annual fee represents something like 0.04% per annum, so good there. Thanks!

I must admit that I've never heard of an annuity like this - probably because it was issued for only a very short time, almost 50 years ago now.

If I've never heard of it, it isn't surprising that the IRS is confused by it also.

calmaniac, it sounds like your father had well over $1 million in the annuity back in 2016. Is that correct? If so, it sounds like this was a wonderful, tax-efficient way to pass down money to heirs.

Could I also ask each of you - what insurance company issued your annuity?

[calmaniac]

Stinky,

Chesapeake Life Insurance Company, now owned by United Health, issued the policy in the 70's.

The actual money is held in an "investment annuity" account under my name with LT Trust (division of American Trust), a 401k provider. Thus, the financial health of the insurer is not an issue as they do not hold the funds, only the policy. The fees are actually very reasonable.

I am no expert, but my understanding is that it is essentially a brokerage account in an annuity/life insurance wrapper. A sleight of hand that was quickly disallowed by the IRS.