IRS Private Letter Ruling Solves Crucial Annuity Transaction Friction Point

A new IRS private letter ruling essentially conforms the tax treatment of properly structured advisory fees from non-qualified annuity contracts to those paid out of qualified accounts, which typically are not treated as taxable distributions.

Nationwide announced it has received a favorable private letter ruling from the Internal Revenue Service (IRS) that concludes the payment of an advisory fee from a variable, fixed indexed, or hybrid non-qualified annuity can be structured to not give rise to a taxable distribution.

Talking about the development with PLANADVISER, Craig Hawley, head of Nationwide Advisory Solutions, stepped through some of the important upshots of the ruling. In basic terms, he says, this new IRS ruling “essentially conforms the tax treatment of properly structured advisory fees from non-qualified annuities with those from qualified accounts such as 401(k)s, 403(b)s and IRAs, which typically are not treated as taxable distributions.”

Importantly, the ruling applies only to fee-based non-qualified annuities, wherein the adviser does not receive a commission related to the sale. According to Hawley, this new ruling is a big deal for the registered investment adviser (RIA) and fee-based adviser communities. It will, he argues, help cut costs and complexity in annuity transactions, allowing RIAs and fee-based advisers to incorporate insurance and annuities into the holistic planning process, to help their clients prepare for and live in retirement.

“My organization within Nationwide was formerly an independent firm, Jefferson National,” Hawley recalls. “We were acquired by Nationwide a few years ago, but we have been working for more than 10 years on building a business that can support RIAs and fee-based advisers with annuity products. We are very pleased with this development.”

As the firm has progressed on this journey, Hawley explains, one of the biggest friction points in serving fiduciary advisers has been the ability to pull a fee out a non-qualified annuity contract. This has been the case because prior to this ruling, the IRS’ view was that drawing such assets out of a non-qualified annuity represented a taxable distribution—no different than taking money out to pay for a new car or to pay the mortgage.

“This IRS ruling now removes this very significant friction point holding back many RIAs and fee-based advisers from the use of fee-based annuities,” Hawley says. “We believe this will open the door to allow advisers to use these solutions in a much more significant fashion.”

According to Hawley, in structuring this private letter ruling, the IRS was sensitive to making sure the fees being drawn and paid to the adviser are in fact integral to the operation of the non-qualified annuity contract. To ensure this, there are a few limitations and stipulations, for example capping the fee at 1.5%.

“That was important because, if you think about the scenario where an adviser is managing $1 million for a customer, and they have $100,000 invested in a fee-based annuity, the IRS didn’t want the adviser to be able to just pull their entire fee for the million dollars of advisory services out of the annuity alone,” Hawley explains. “The IRS wanted to make sure the fees were only related to advising on the annuity itself—so this wouldn’t become a way to open up a tax-deferred Pandora’s Box where you could effectively gut the money out of the tax-deferred structure, tax free, to pay for the services on the taxable account. They wanted to make sure the fee is tied to the work being done inside the contract.”

Hawley adds that, because of the way insurance and annuities have typically been transacted in the past, they often didn’t fit into an RIA’s or a fee-based adviser’s compensation model.

“RIAs and fee-based advisers don’t want to act as the agent of an insurance company,” he says. “They don’t want to receive a commission because they view this as a conflict of interest against their fiduciary duties. So, this step is about creating solutions that fit into this fiduciary ecosystem. It’s a fantastic development from that perspective and should help advisers be even more holistic.”