Basis Exceeds Amount of Refund

[Guest CRC02]

A participant contributes $10,000 in after-tax contributions to a plan. These are the participant's only contributions. The participant elects to receive a distribution from the plan in the form of a life annuity. The participant receives a benefit of $9,000 during his first year of distributions, $1,000 of which is attributed to the participant's basis in the annuity contract and is not taxed. The participant dies after receiving only one year's worth of annuity payments. Under the terms of the plan, the participant's spouse is entitled to a refund of the difference between the participant's contributions to the plan and the amount of benefit received by the participant.

The participant's spouse is only entitled to a refund of $1,000 (total contributions of $10,000 less annuity payments of $9,000). However, as the participant's basis was $10,000, and only $1,000 of that basis was distributed to the participant, the participant has an additional $9,000 of basis in the plan. Clearly, the $1,000 the spouse is entitled to receive is not taxable. But what about the remaining $8,000 ($9,000 less $1,000 paid to spouse) of basis? Is it simply lost? Can it be deemed a loss on the participant's final tax return or on the spouse's return in the year the refund is made?

[Mary Kay Foss]

Section 72 of the IRC says that "unrecovered investment" as of the death of the annuitant are deductible on the final income tax return. See 72(b)(3) and (b)(4).