1982 – TEFRA
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) was really the first significant piece of legislation to have an impact on annuities. Prior to 1982, the contract owner was allowed to recoup fully his or her invested principal first before any interest was deemed to be distributed. Any withdrawals beyond that represented interest, which is fully taxed. This approach to taxing withdrawals is know as “first-in, first-out” (FIFO) – that which is first put in (principal) is considered first to be paid out.
FIFO to LIFO
The first step was to change the tax treatment of annuity distributions from “first-in, first-out” to “last-in, first-out” (LIFO). This means that any distribution prior to maturity will now be treated as first a return of taxable interest, until all interest is recovered, and only then will nontaxable principal, or basis, be recovered.
Penalty on Interest Withdrawal
Congress also imposed a 5% penalty on any interest withdrawal a contract owner took before the age of 591/2, except for those taken in the event of death or disability, over a five year (or longer) period or in cases where the annuity was held for at least 10 years prior to the distribution. Any annuity issued prior to the effective date of August 14, 1982, was grandfathered from these TEFRA regulations and remains so today.
1984 – DEFRA
The Deficit Reduction Act of 1984 (DEFRA) changed one of the exceptions to the 5% penalty tax. Specifically, it disallowed the 10-year holding period exception. This act also provided that distributions must be made from any deferred annuity at the time of the contract owner’s or annuitant’s death. Previous annuity ownership could be passed by will, allowing for multigeneration tax deferral. Any annuity issued prior to January 1, 1985 was grandfathered from DEFRA rules.
1986 – TRA
The Tax Reform Act of 1986 (TRA) changed the penalty for pre-591/2 distributions was raised from 5% to 10% and another exception to the penalty – the five-year payout exception – was disallowed. This meant that the penalty for pre-591/2 distributions was 10% and the only exceptions were distributions taken at death, disability or as payment over life expectancy. There is no grandfather provision for these TRA 1986 changes.
The other significant effect this act imposed on annuities was to eliminate the tax-deferred inside build-up of corporate-owned annuities.
1988 – TAMRA
The Technical and Miscellaneous Reform Act of 1988 (TAMRA) had yet another change for annuities. Congress found that instead of buying, say, one annuity contract for $100,000, individuals were buying ten $10,000 contracts. They would then take distributions from one contract, the amounts of which exceeded interest earnings credited to the one contract. This meant that these distributions would be deemed a return of principal and only partially taxed. Congress considered this to be abusive. Therefore, they instituted what has become known as the “aggregation rule.” This rule states that all annuities purchased within one calendar year will be aggregated and treated as one contract for the purposes of determining taxation of withdrawals. The effective date of this requirement was October 22, 1988. Annuities purchased prior to that time are grandfathered from this provision.
1996 – Small Business Act
The Small Business Job Protection Act of 1996 contained a number of provisions related to qualified plans and pension simplification. It affected the taxation of qualified annuities by modifying the exclusion ratio formula used to determine plan participant basis and the nontaxable portion of qualified annuity payments.
Last Updated: 9/23/2012 10:05:00 PM