Question

In 2016 Todd purchased an annuity for 150,000. The annuity is to pay him2,500 per month for the rest of his life. His life expectancy is 100 months. Which of the following is correct?

1) If Todd collects 20 payments and then dies in 2017, Todd's estate should amend his tax returns for 2016 and 2017 and eliminate all of the reported income from the annuity for those years.
2) Todd is not required to recognize any income until he has collected 60 payments (=$150,000).
3) For each $2,500 payment received in the first year, Todd must include $1,000 in gross income.
4) For each $2,500 payment received in the first year, Todd must include $1,500 in gross income.
5) None of the above

Answer 1

The correct statement regarding Todd's annuity income is that for each $2,500 payment received in the first year, Todd must include $1,000 in gross income. This is based on the exclusion ratio, which determines the taxable and non-taxable portions of each payment from the annuity.

Step-by-step explanation:

When Todd purchases an annuity for $150,000 that pays him $2,500 per month based on his life expectancy of 100 months, the income recognized from the annuity must be determined based on the exclusion ratio. This ratio is calculated by dividing the cost of the annuity ($150,000) by the expected return (100 payments of $2,500 each, totaling $250,000). Each payment Todd receives is partially a return of his initial investment (which is not taxable) and partially income (which is taxable).

The exclusion ratio for Todd's annuity is $150,000 / $250,000 = 0.6. Therefore, 60% of each payment is a non-taxable return of principal, and 40% is taxable income. For each $2,500 payment, this means $1,000 ($2,500 * 0.4) must be included in gross income. The correct statement in this context is: For each $2,500 payment received in the first year, Todd must include $1,000 in gross income.

If Todd dies after collecting 20 payments, this tax treatment doesn't change, and there's no need to amend past tax returns to eliminate reported annuity income. Therefore, the option (1) is incorrect. Option (2) is not correct because income recognition starts with the first payment, not after recovering the cost of the annuity. Option (4) incorrectly states the taxable amount, and option (5) is not applicable as one of the provided statements is indeed correct.