Annuity Taxes Made Easy
The subject of annuity taxes can be confusing and loaded with jargon. But there is a simpler way to approach annuity taxation, based on the fact that the way an annuity is taxed depends primarily on the type of annuity in question. And since there are only two major types of annuities, it follows that annuity tax applies in two major ways only, which we will examine briefly.
The two main types of annuities (in terms of income from the annuity) are immediate annuities and deferred annuities. Immediate annuities are usually purchased through the payment of a lump-sum payment to the company selling the annuities, and the annuity holder usually starts drawing income from the annuity immediately upon the purchase of the annuity, or at least within a year of the purchase of the annuity. In deferred annuities, the annuity-holder buys the annuity by making a number of payments to the annuity offering company, until he has paid for the whole value of the annuity. Thereafter, the annuity-holder receives payment(s) from the annuity company, either as one lump-sum payment or as regular payments for the rest of his life or up to a pre-agreed annuity expiry date.
Now all annuity taxation is based on a taxation principle called ‘capital gains taxation,’ in which only the gains (earnings) from the capital are taxed, and not the capital itself. Thus in the case of annuities, the amount with which you bought the annuity is considered the capital, and any extra money you earn on top of what you put into the annuity is considered the capital gain to be taxed.
In the case of a lump-sum payment from the annuity, the whole matter is quite clear-cut, because determining the capital gain is just a matter of subtracting the final sum the annuity holder receives from the annuity from the amount he paid into it. The difference between the two is the capital gain and is what is subjected to taxation, usually at current income tax rates at the time of the payment.
On the other hand, in the case where the annuity holder opts for the regular payments from the annuity rather than one lump-sum payment, these payments are considered by the taxman to be part capital and part capital gain. In keeping with the principle of capital gain taxation, the capital gain part of the regular payments is subject to income tax at the going rates, whereas the capital (principal) part is exempted from such taxation. In this case, the taxman applies a formula called the exclusion ratio to determine which part of the regular payments is a capital gain (to be taxed) and which part of the payment is the capital (to be exempted from taxation).
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