Nonqualified Annuity, Early Withdrawal

Technical topics regarding tax preparation.
#1
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I have a client that invested $125K into a nonqualified annuity with a big bank with post tax funds just hanging out in a regular checking account. The client had family situation occur that forced him to take the $125K out. The big bank took out 10K and the client received a notice assessing a 10% early withdrawal penalty. Is there anyway to get abatement by responding to the notice that the $115K that the client received was from his original investment?

From publication 575:

"Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income. It doesn't apply to any part of a distribution that is tax free, such as amounts that represent a return of your cost or that were rolled over to another retirement plan."
 

#2
Nilodop  
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The big bank took the $10k, I assume, as a penalty because of the terms of the annuity contract. But how much of the $125k was accrued/earned income? Did he take everything out? If so, show us the calculation. For example (but use the real numbers):
Invested $125k
Earned $3k
Withdrew $118k
Ins. co. took $10k penalty.

Might you be conflating early w/drawal penalty with ins. co. penalty?

When did all this happen, and did he receive a notice of an IRS penalty? The latter would be pretty small, if any.
 

#3
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Hi Nilodop,

The client is dropping a copy of the notice off next Tuesday. Figured I'd do my research ahead of time. From what he has described to me, a few months before the family situation he invested the funds in the nonqualified annuity through the big bank. Only a few months passed and he took the funds out. Here's the calculation:

Invested $125,000
Earned -0- (or next to it)
Big Bank Penalty $10,000
Withdrew $115,000

He received a CP2501 notice proposing a 10% penalty on the $115,000 for his 2020 return, which I did not prepare. For the few months the funds were invested there could have been a very small amount of earnings, but from what the client has indicated, it appears that 99.9% of the penalty is on his own funds he invested.

Thank you!
 

#4
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He received a CP2501 notice proposing a 10% penalty on the $115,000 for his 2020 return,


See what Big Bank 1099-R had in taxable income box 2. They should have reduced the Gross amount by his basis in the annuity.
 

#5
Nilodop  
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Exactly. No income, no IRS penalty.

Next question - tax treatment of the loss due to the big bank penalty. I believe it's an ordinary loss, deductible.
 

#6
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Next question - tax treatment of the loss due to the big bank penalty. I believe it's an ordinary loss, deductible.


2% misc itemized deduction since Revenue Ruling 61-201 ( ordinary loss on a refund annuity) was issued before miscellaneous itemized deductions were enacted. There is a code section (IRC 62?) that states that deductions above the line must be given in a specific code section. If not given in a code section, the deductions must be taken as itemized deductions. The 2% Misc itemized treatment would be consistant with the treament of IRA and 529 losses.
 

#7
Nilodop  
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2% misc itemized deduction since Revenue Ruling 61-201 ( ordinary loss on a refund annuity) was issued before miscellaneous itemized deductions were enacted.. But 61-101 is about a loss, not an expense covered under sec 67 (itemized deductions). And the loss is from a "surrender" not a "sale or exchange".


If not given in a code section, the deductions must be taken as itemized deductions.. The loss is from a transaction entered into for profit, as described in sec 165.

The 2% Misc itemized treatment would be consistant with the treament of IRA and 529 losses.. But it's not one of those. It would also be consistent with 62(a)(9) but probably not one of those either.

Are you saying we are stuck with treating it as disallowed by sec 67(g)? Would it not be outside the purview of the 2% floor type of deductions that are suspended?
 

#8
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Are you saying we are stuck with treating it as disallowed by sec 67(g)?



Yes.
The most widely accepted treatment is to report the loss as a 2% miscellaneous itemized deduction. There is no official IRS confirmation of this position, but Bruce I. Friedland, a spokesman for the IRS, was quoted in a Wall Street Journal article on Dec. 6, 2002, as saying the IRS has accepted this treatment in the past and will continue to do so.
 


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