IRS Notice 87-13 and Grandfathered Annuity Tax Rules

IRS Notice 87-13 provides guidance from the Internal Revenue Service regarding the tax treatment of distributions from deferred annuity contracts. It clarifies how contracts issued before a 1982 tax law change are treated, particularly when new funds are added to these older contracts. The notice establishes which set of tax rules applies, resolving ambiguity created by the legislative shift.

Annuity Taxation Before the 1982 Tax Act

Before the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), distributions from deferred annuity contracts entered into before August 14, 1982, were governed by the “First-In, First-Out” (FIFO) accounting method. This approach treated the first dollars withdrawn from the contract as a return of the owner’s original investment, also known as the cost basis.

The cost basis is the total amount of premiums paid into the annuity. Under pre-TEFRA FIFO rules, an owner could take withdrawals free of income tax until they had recovered their entire investment in the contract. Only after withdrawals exceeded the cost basis were any further distributions considered taxable income, allowing accumulated earnings to be withdrawn last.

The Shift to LIFO Treatment After the 1982 Tax Act

The Tax Equity and Fiscal Responsibility Act of 1982 changed the rules for new annuity contracts. For contracts entered into after August 13, 1982, Congress replaced the FIFO method with a “Last-In, First-Out” (LIFO) method, which assumes that earnings are withdrawn before the owner’s principal.

Under this LIFO regime, any withdrawal from a post-TEFRA annuity is first treated as a distribution of taxable earnings. This means a non-annuitized distribution is subject to ordinary income tax up to the full amount of gain in the contract. Only after all earnings have been distributed and taxed can the owner begin to withdraw their original investment tax-free.

This legislative change also introduced a penalty to discourage the use of annuities as short-term investments. A 5% tax penalty was imposed on any taxable earnings withdrawn from an annuity before the owner reached age 59½. This penalty, which applies on top of the ordinary income tax, was later increased to 10% under the Tax Reform Act of 1986.

Core Provisions of IRS Notice 87-13

IRS Notice 87-13 was issued to address how the new LIFO rules would apply to pre-existing annuity contracts. The notice confirmed that contracts entered into before August 14, 1982, would retain their FIFO tax treatment on all funds present in the contract as of that date.

The notice also addressed what happens when new money is added to a grandfathered contract. Notice 87-13 established a “dual-accounting” system for any pre-TEFRA annuity that received additional premium payments after August 13, 1982. This system segregated the contract’s funds into two distinct portions for tax purposes.

Under this dual-accounting framework, the contract is divided internally. The first portion consists of the investment in the contract and earnings as they stood on August 13, 1982, and this part remains subject to FIFO rules. The second portion consists of all premiums paid after August 13, 1982, and all earnings on those new contributions; this part is subject to LIFO rules.

This segregation results in a specific ordering rule for withdrawals. A distribution is deemed to come first from the post-1982 LIFO portion, meaning the owner must first withdraw and pay income tax on all earnings from the newer contributions. Once that LIFO portion is depleted, any further withdrawals are sourced from the pre-1982 FIFO portion, allowing the owner to receive their original basis tax-free.

Calculating Distributions from Grandfathered Contracts

To understand the application of Notice 87-13, consider an individual who purchased an annuity in 1980 with a $50,000 premium. In 1985, they added another $20,000 to the contract. Today, the contract’s value is $150,000, consisting of $70,000 in total premiums and $80,000 in earnings. The earnings are tracked, showing $60,000 of growth is from the original 1980 investment, and $20,000 is from the 1985 investment.

Assume the owner, who is over age 59½, takes a partial withdrawal of $30,000. The withdrawal must first be sourced from the post-August 13, 1982, funds under the LIFO method. The post-1982 portion of the contract contains $20,000 in premiums and $20,000 in earnings. The LIFO rule dictates that earnings come out first, so the first $20,000 of the withdrawal is a distribution of taxable earnings from this portion.

The total withdrawal was $30,000, so after exhausting the $20,000 of post-1982 earnings, $10,000 of the distribution remains. This amount is sourced from the pre-August 14, 1982, portion of the contract, which is governed by FIFO rules. Under FIFO, withdrawals are treated as a tax-free return of the investment first, so this $10,000 withdrawal is a partial return of the $50,000 basis and is not taxable.

Therefore, of the total $30,000 distribution, $20,000 is taxable as ordinary income, and $10,000 is received tax-free. The remaining basis in the pre-1982 portion of the contract is now reduced from $50,000 to $40,000 for calculating the tax on future withdrawals.