One of the more attractive features of an annuity is tax-deferred growth. As long as the money remains inside the annuity, the government won’t tax any of the earnings.
A deferred annuity has two phases, the accumulation phase and the distribution or payout phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. During the distribution phase, the annuity is paid out. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime.
Income taxes will be due on most annuity payments the annuitant receives, regardless of the payment method. If the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into that annuity and its value when it is paid back.
Taxes on a Lump-sum Distribution
As an example, let’s say you invested $100,000 over the years into an annuity that’s worth $300,000 when you retire. If you take a lump sum distribution, you will owe taxes on the gain of $200,000. Taxes on the gain will be taxed at ordinary income tax rates in the year of the distribution. Most critics of annuities will suggest that this is unfair, and makes annuities less attractive because distributions do not qualify for capital gains tax treatment. What they often fail to mention is the investments owned by annuities, such as mutual funds or CD-like investments, don’t receive much, if any, capital gains tax treatment to begin with.
Taxes on Annuitization
If you annuitize the distribution is place into two categories, one is considered as a return of principal (i.e., your investment) and the other as part of earnings. The annuitant will owe income taxes on the part of the payment that’s considered earnings. The amount of each payment that won’t be taxed is computed by establishing an exclusion ratio. The exclusion ratio can be determined by dividing the investment in the contract by the total amount expected to receive during the payout period.
As an example, assume you have a fixed annuity in which you’ve invested $100,000 that will pay you a sum of $1,000 per month for life starting at retirement age 65. According to IRS life expectancy tables, you will receive those payments for 15.0 years, so your contract’s value is $180,000 (12 X $1,000 X 15.0). Your exclusion ratio is 55.5% ($100,000/$180,000). Therefore, out of the $12,000 the annuity pays each year, you may exclude $6,660 from income. The remaining $5,340 of that payment will be subject to ordinary income taxes.
Taxes on Variable Annuities
With a variable annuity, it is difficult to predict how much the annuity payment will be each month because the market value of the investment will change based upon the performance of the market. As a result, the excludable amount of each annuity payment is determined by dividing the investment by the period of time the annuity is expected to be received.
In the prior example, the annuity would payout for 180 months (12 X 15.0). If the annuity was a variable annuity, the amount to be excluded from the monthly payment would be $556 ($100,000/180). The remainder of each payment would be declared and taxed as income for that year.
What Happens If a Withdrawal is Made Without Annuitization
A withdrawal is any amount distributed from the annuity that is not part of an annuitization payment. Withdrawals are taxed based on when the annuity was purchased. Investments made after August 13, 1982, are taxed on a last-in, first-out basis. This means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the annuity. Also, withdrawals made prior to the annuitant’s age 59 1/2 are subject to a 10% early withdrawal penalty.
This material does not constitute tax, legal, or accounting advice, and neither AnnuityScene.com nor any of its agents, employees, or registered representatives are in the business of offering such advice. It cannot be used by any taxpayer for purposes of avoiding any IRS penalty. Anyone interested in these transactions or topics should seek advice based on individual circumstances from independent professional advisors.
