Taxation and Annuities

The popular axiom, “Nothing is certain except death and taxes”, has become a rallying cry for our tax adverse society to the point where most people spend a great deal of their time trying to avoid both.  People who buy annuities may very well be challengers of both death and taxes.  When an annuity is purchased to generate a lifetime income, annuity owners are, essentially, making a bet with the insurance company that they will outlive their life expectancy.  And, it is also well known that annuity owners, in their quest to legally avoid taxes, enjoy the favorable tax treatments of annuities.  While we can’t provide any enlightenment to the notion death avoidance, we can provide some information that can shed some light on annuity taxation.

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Annuity History

Annuities were created as a way for individuals to safely save for retirement and secure a dependable lifetime income.  Because they meet many of the same tax code requirements, annuities have been granted similar status as qualified retirement plans such as IRAs.  So, in essence, they exist to allow people to avoid taxes while providing a means to create a secure retirement.

Studies have shown that most annuity owners buy annuities specifically for the tax-deferred treatment of the earnings within the annuity contract.  And, for most people, tax-deferred growth is a fairly easy concept to understand. Simply, as long as the funds remain inside the annuity, the earnings won’t be taxed.  The result is that, over time, the funds accumulating in the annuity will grow faster than if the earnings were taxed currently.

If that were the only taxation issue, annuities would be fairly straightforward and easier to understand.  There are, however, other tax issues of which annuity owners need to be aware. 

Annuity Taxation

Deferred annuities consist of two stages, the accumulation stage and the distribution stage.  It is during the accumulation stage when the funds are allowed to accumulate without being taxed.  During the distribution stage, the annuitant begins to receive his or funds, either in the form of withdrawals or as income payments which are made for a specific period of time or over the annuitant’s lifetime. It is during the distribution stage that taxes are due and the piper must be paid.

Taxation of Withdrawals

Withdrawals from deferred annuities can be made at any time and they are always subject to taxes.  When withdrawals are made, the IRS considers the first money to come out of an annuity to be interest earned which is taxed as ordinary income.  If there is $100,000 in an annuity and the original investment was $50,000, then the first $50,000 to be withdrawn will be the taxable interest portion. Once the interest portion has been withdrawn the rest will be considered principal which is not taxable.

The converse is true if the annuity was purchased prior to August 13, 1982.  For these annuities, the first money to come out is principal and, therefore, taxes would not be owed until the entire principal is received from the annuity.

If the annuity is surrendered, say at retirement, it is considered a lump sum withdrawal.  If the amount surrendered is $100,000, ordinary income taxes will be due on the interest portion.

In all cases of withdrawals, if they are made prior to age 59 ½, the IRS will apply an additional penalty of 10% to the amount withdrawn.

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Taxation of Annuity Income

When an annuity is converted to income, or annuitized, the portion of each payment that is considered interest earnings is taxed as ordinary income.  The other portion is considered to be a return of principal and is not taxed.  The amount of the principal (untaxed) portion of the payment is calculated using an exclusion ratio that is a formula that takes your total expected income and divides it by your total principal and is expressed as a percent of your monthly payment.  For example, if your expected earnings from an annuity are $200,000 and your total investment is $100,000; your exclusion ratio is 50%. So, if your monthly annuity payment is $750, the principal portion is calculated to be $375.

Taxation of Death Benefit

When annuity death benefit proceeds are paid to a beneficiary, they are taxed just as if the annuitant received a lump sum withdrawal. The portion of the proceeds that are earnings will be taxed as ordinary income.  If, however, the annuitant dies after annuitization, the tax treatment may vary depending on the way the annuity was structured.  For instance, if the annuitant is receiving income based on a life-only option, then all income payments stop upon his or death, so there is no tax consequence.  If an income option was selected that included a guarantee period or refund period, then the balance of payments will be paid to a beneficiary, and the earning portion will be taxed.  In the case where a joint-life option was selected, the annuity payments would continue to the survivor and the exclusion ratio would apply.

Summary

Annuity taxation is not terribly complex; however, it is important to have a clear understanding of their tax treatment as it applies to the various components of the contract.  The different tax aspects of the annuity may have a bearing on how the annuity is incorporated into retirement and estate plans.  Because annuities involve several tax issues, it is strongly recommended that you seek the guidance of a qualified financial professional when considering annuities for your retirement plans.

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