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Policy letter; Taxation of Annuities, Your Letter, 12/3/90

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Re: Iowa Inheritance Tax, Taxation of Annuities, Your Letter, 12/3/90

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Your letter to Mr. Dan Bever has been referred to me for reply. I should note that the "Estate and Trusts Division" of the Department no longer exists. Mr. Bever currently is employed by the Department's auditing division. I should also introduce myself. My name is Darwin Clupper. I am a technical tax specialist III with the Department's Policy Section. My usual area of concentration is Iowa sales and use tax law. However, with the recent retirement of Mr. Ben Brown, I am also attempting to develop expertise in the area of inheritance tax. Also, please accept my apologies for the lateness of our response.

I begin my answer to your letter with the observation that as of January 1, 1991 all IPERS benefits are subject to Iowa income tax, January 1, 1991 being the date for the repeal of 422.7(23) of the Iowa Code. Prior to that date the "commuted" value of that portion of IPERS benefits excluded from Iowa income tax was subject to Iowa inheritance tax. The amount excluded was the lesser of any amount contributed by the employee/annuitant or $2,500 in the case of an individually-filed return, or $5,000 in the case of a jointly-filed return.

Your next inquiry concerns the Department's existing rules for inheritance taxation of tax sheltered annuities purchased by or for decedents employed by governmental bodies or nonprofit organizations, for example, hospitals. Your letter states and inquires:

It is my understanding that at one time it was the Department's position that to the extent that the employer contributed the money to this account, this was an exempt asset and not includible in the inheritance tax return of the decedent. To the extent that the employee, however, may have made a contribution of his own to the tax-sheltered annuity account, the same would be includible in his estate for inheritance tax purposes just like any other asset. What are the present rules on tax sheltered annuities for inheritance tax?

The existing rules on tax sheltered annuities are the same as set out in the above quotation from your letter. It is the Department's position that the somewhat unique interworkings of Iowa Code 422.7(4) and 450.4(5) require that the portion of any annuity derived from an employer's contribution of funds be subject to Iowa income tax when withdrawn and the portion of any annuity derived from an employee's own funds be includible in the employee's estate under 450.3(3) of the Code. In summary, what in your understanding was at one time the Department's position remains the Department's position. I would add to my answer to your second question this observation: That portion of an annuity payment which represents income (e.g. dividends, interest or capital gains) earned from funds deposited either by an employer or an annuitant is subject to Iowa income tax and excluded from Iowa inheritance tax.

Your understanding of the requirement for exclusion from inheritance tax for annuity payments under IRA's, KEOGH, and HR-10 plans is correct. I will summarize the three main requirements briefly, adding a bit to what is in your letter: 1) The source of funding for the annuity must be what the Internal Revenue Code refers to as a "qualified retirement plan". Under a qualified retirement plan, some portion, at least, of the funds which are the source of an annuity are subject to income tax at the time the annuity payments are made rather than at the time the funds are earned. 2) Some portion of the annuity payment must be subject to Iowa income tax; if no portion of the annuity payment is subject to Iowa income tax, no portion of the annuity payment is excluded from Iowa inheritance tax under 450.4(5) of the Code. 3) Finally, distribution must be in "installments" rather than in one lump sum. The Department does not require any specific lapse of time between installment payments, so long as the beneficiary receives the annuity in at least two payments. You are correct in your assumption that a "roll over" from one qualified employee pension plan to another, prior to the death of the employee, would not be a "lump sum distribution" which would exclude any subsequent annuity payment from the protection of 450.4(5).

Finally, with regard to the questions you ask in the next to the last paragraph of your letter, my general answer is that all "annuities" are judged for the purposes of inheritance taxation and exemption by the above standards. The standards used to judge taxation and exemption are not altered by the fact that some portion of the source of funding for an annuity came from a decedent, and, if the entire amount of an annuity payment is subject to Iowa income tax, then none of that payment is subject to Iowa inheritance tax. If a portion of the payment is subject to Iowa income tax, the rules which I have previously discussed should be applied.

I hope that my observations have been of help to you. In closing I must give my usual warning. My observations and conclusions are "informal" only. Because of this, if they are in error, the Department could, in the future, take a position contrary to them.

Sincerely, Darwin D. Clupper Tax Specialist, Policy Section Technical Services Division