Qualified Annuity funded with non-qualified funds

[dhoyt]

Hi all. I have an odd situation I've never seen before. I have a client who purchased a qualified annuity for about $140,000. She used funds from 2 accounts to purchase it. One acount was an IRA she rolled over of $90,000, the other account was a non-qualified account of $50,000, almost all of which was not taxable. All of this was put into the same taxable qualified annuity. According to the insurance company there is no way to undue this.

So what do we do about that $50k of non-taxable funds. Can we set up basis for it on an 8606? Anyone have this happen before and have any advice? Thanks for any help you can provide.

I hope your tax seasons have been good and that you all get a much earned rest on the 16th!

[BobKamman]

What is a "taxable qualified annuity" ?  If it's taxable, it's not an IRA.  But if it's an IRA, and nonqualified funds were contributed to it, you need to withdraw them yesterday.  

[dhoyt]

Sorry if I didn't make that clear. She rolled her traditional IRA over to purchase this Annuity IRA. Then she also took 50k from another account (some sort of annuity that the 50k was almost all not taxable on the 1099R ) and put it into the same IRA annuity that I believe she will get monthly payments for the rest of her life from. So the total cost of the new annuity is 140k, but part of it came from qualified funds, and part from non-qualified funds. On the 1099R she received from the insurance company for the new annuity it has the IRA box checked.

[BobKamman]

Did she do this with no help from a professional, or is there a commission-hungry agent who can be sued?  (Or, more likely, named in a complaint to the state insurance department along with the company that accepted the "rollover.")  So she bought the annuity with illegal funds, then annuitized, and the new company refuses to help.  This is a situation where she doesn't ask them to reverse the deal; she tells them to do it.  If you can't help her, find a lawyer who can.  

[dhoyt]

The agent involved was a family member, and either he was unaware of where all the funds were coming from, or he didn't understand how this works. He was fairly new to this kind of work. I believe the contributions were not directly transfered to the insurance company,  she got the checks and gave them to the agent. I don't know exactly how that process works or what responsibility the agent had to verify the sources of the funds. But either way I don't think she is going to sue her family.

I've been talking to the family member/agent's boss, and she is the one who told me yesterday it is just too complicated to undue. But I will call her today and tell her she better figure out a way to do it. 

Thanks for your help!

[BobKamman]

You definitely have a Tar-Baby case there, that you will regret ever getting involved with if you continue to devote uncompensated time into trying to fix.  The best thing for you to do now is prepare an extension for her and tell her to find someone else to work on the mess.  Make sure she includes the 6% penalty for excess contributions.   I suppose that can be reduced every year as the annuity payments draw down the $50,000.  

[qbteachmt]

I read and reread this yesterday, and it made no sense to me, either. This is commingling.

This: "On the 1099R she received from the insurance company for the new annuity it has the IRA box checked."

That's not what this was. A 1099-R is issued for money Out. The IRA brokerage or other entity holding her Trad IRA account would issue this because there was a distribution or disbursement or transfer from them. This is either a taxable event, or it went to a "like kind" tax deferred qualified account (say, to another Trad IRA) and that avoids being a taxable event.

The new annuity, if it also paid out, has its own reporting.

Or, the annuity is inside of the IRA? In which case, you still can't commingle.

Sales people get it wrong, often, but they legally need to unwind something that is disallowed.

Someone needs to lose their insurance sales license, as well.

[dhoyt]

I agree it is absolutely commingling. This is what happened for better clairification:

Company A paid 90K to taxpayer from an IRA, reported code 7 distribution, IRA box checked, on 1099r.

Company B paid 50k to taxpayer, reported  code 7 distribution, IRA box not checked on 1099R. Taxable amount in Box  2a was only $60. 

Both amounts were deposited with Company C. According to the agents after discussing it with them further this morning, their notes separated the funds as qualified and non-qualified but when they were given to Company C, they were commingled and all put into the same qualified annuity.

Company C reported on 1099R 9k income, code 7, IRA box checked.

I told the agent they need to get it fixed. They are working on it. I have the taxpayer on extension so they can get this mess fixed.

[qbteachmt]

"their notes separated the funds as qualified and non-qualified but when they were given to Company C, they were commingled and all put into the same qualified annuity."

Thanks for the review.

Once the funds were removed from the IRA, they are just like any other funds your taxpayer can spend. That large distribution event is taxable.

Once the funds were removed from the nonqualified plan, which typically is taxed while the taxpayer worked there and had the "rights" to the funds, only earnings would be taxable, when distributed. This is because a nonqualified plan typically is a salary or compensation deferral plan, which is taxed as compensation at the time awarded (think of how a bonus might work) but not given to the employee (so, not yet income). It is not unusual for a nonqualified plan to tax only Medicare and Social Security, then the FIT is part of the disbursement event (when they still work for them). So, once distributed, it's just like any other funds your taxpayer can spend. That partial event is taxable; the other part likely was taxed on a W2 year(s) ago.

So, there is no commingle. There is only Taxpayer's own funds. And the sale is the wrong product. The taxpayer is now exposed to double taxation.

A non-qualified annuity is purchased with after-tax dollars, so that only the earnings are taxed. A qualified annuity would continue to shelter tax deferred funds.

"A qualified annuity is one that has been purchased with pre-tax dollars... Only the earnings of a non-qualified annuity are taxed at the time of withdrawal, not the contributions, as they are after-tax money."

https://www.investopedia.com/terms/q/qualified-annuity.asp

Don't let the taxpayer work with the same people. They already made a mess.

[dhoyt]

"Once the funds were removed from the IRA, they are just like any other funds your taxpayer can spend. That large distribution event is taxable."

The funds were deposited with the new company within 60 days. So it should qualify as a rollover, right?

[qbteachmt]

"So it should qualify as a rollover"

Well, then you are back to commingled funds. Either it's not a rollover, but an investment of disbursed funds and the wrong purchase. Or, it is a commingled purchase.

I think you should find a mentor that is a trusted licensed insurance broker for investments. Not the taxpayer's friend.

[BobKamman · Accepted solution]

The rollover from one IRA to another is not the problem.  Usually these are done trustee to trustee, when they are annuities, but that isn't a requirement.  The problem is depositing another $50,000 in cash that did not come from an IRA rollover.  She can just keep paying the $3,000 annual penalty until she figures out a way to put the toothpaste back in the tube.  

This is not the fault of the new annuity company, but they could solve the problem just by breaking the one contract into two contracts with identical terms.  

[dhoyt]

Yup this is exactly what they are going to do. So it should work out in the end. The extension will buy them time to fix it and avoid the 6% penalty.

Thanks to all of you for your help and education on this situation. 

[qbteachmt]

Thank you, too. Weirdly interesting scenario.