Most discussions of annuities focus on the security and predictability they offer as a retirement-planning tool. And for good reason. Guaranteed growth, minimal risk, and a consistent income stream for life are big advantages for retirees.
But favorable tax treatment, though perhaps not as immediately attention-grabbing, may be just as important.
With a little strategic planning and an understanding of how annuities are taxed, you can maximize the percentage of your nest egg that benefits you and your family.
After all, every dollar you don’t have to pay to the IRS is one more dollar you can use to fund your retirement.
Qualified vs. Nonqualified Annuities
There are dozens or more different types of annuities, but the distinction of greatest concern to the IRS is whether an annuity is “qualified” or “nonqualified.”
The difference boils down to whether the annuity’s premiums were paid using pre-tax dollars (qualified) or already-taxed dollars (nonqualified).
Neither is “better” than the other, but they are taxed differently, which can have a significant impact when planning for retirement.
Nonqualified annuities, which make up a large majority of all annuities purchased, are funded using money that has already been taxed.
As a result, distributions from a nonqualified annuity only count as taxable income to the extent the payment amount is attributable to growth.
Any withdrawal or distribution consisting of “return of premium” (i.e., repayment of the original investment) is not taxable.
Premium payments can’t be deducted, and nonqualified annuities are not subject to any tax penalties for early withdrawals – though individual annuity contracts often include surrender fees for the first few years after the annuity is purchased.
Qualified annuities are acquired as part of a formalized retirement plan, usually through an employer plan but sometimes through an IRA.
Because premiums are paid with pre-tax money, distributions from a qualified annuity are taxable income, except to the extent contributions to the annuity were also made with already-taxed money.
If premiums included both pre- and after-tax dollars, the taxable portion of distributions is calculated based on the ratio between the two.
Like other pre-tax retirement plans, qualified annuities have tax penalties for early withdrawals and are subject to annual “required minimum distributions” beginning at age 70.5.
However, unlike IRAs and 401ks, qualified annuities are generally not subject to annual contribution limits, making them particularly useful if you weren’t able to put back much money for retirement earlier in your career and need to play catch up.
Qualified Longevity Annuity Contract (QLAC)
A special category of qualified annuity known as a QLAC (Qualified Longevity Annuity Contract) allows you to purchase an annuity using funds from your 401k or IRA.
For the most part, QLACs are single-premium, fixed-payment, lifetime annuities, with a maximum premium of $130,000 or 25% of the balance of the originating IRA or 401k.
Pay-outs for QLACs can be deferred until as late as age 85, making them particularly useful in minimizing tax liability arising from required minimum distributions.
Whether qualified or nonqualified, annuity distributions subject to income tax are taxed at the rate applicable to the tax year in which the distribution occurs.
Importantly, due to a principle known as “deferred growth,” no taxes are owed on annuity earnings until the money is paid out by the insurance company.
With both qualified and nonqualified annuities, growth isn’t taxable income as long as it stays in the annuity.
Instead, the money continues growing tax-deferred until paid out by the insurance company. This allows an annuity’s earnings to continue compounding year after year without reduction for taxes.
When the annuity’s value is distributed by the insurance company or withdrawn by the annuitant, the growth is then taxed as income for the year received (as opposed to the year the growth was earned).
The principle of deferred growth is the same whether an annuity is immediate or deferred, or fixed, variable, or indexed.
An annuity that defers pay-outs for ten years can grow and compound during the entire deferral period with no current taxes owed.
Or, funds can be shifted between investments linked to a variable annuity without realizing gains at the time.
Thus, a nonqualified annuity lets you enjoy one of the benefits of an IRA without being tied down by the tax penalties for early withdrawals.
The advantage of deferred growth is limited to annuities owned by a “natural person,” a decedent’s estate, or a trust for the benefit of a natural person.
An annuity owned by an LLC, corporation, or similar entity does not get the benefit of deferred growth.
Calculating Taxable Growth for Nonqualified Annuities
Because payments from qualified annuities are taxable in full, the distinction between return of premium and growth in a specific distribution is usually not all that relevant to income taxes.
With nonqualified annuities, though, only the growth is taxed, so determining the portion which is attributable to growth – and which is therefore taxable income – becomes very important.
Calculating Taxable Gains
For some investments, calculating taxable gains is fairly straightforward. When you sell stocks, for instance, you subtract your cost basis (i.e., what you paid for the shares) from the sale price, and the difference is growth.
Annuities change the equation because you usually aren’t receiving all of the money at once (though some deferred annuities provide for lump-sum payments after the deferral period).
And, with a lifetime annuity, you can’t be certain of the total payments you will ultimately receive because you don’t know precisely how long you will end up living.
Insurance companies calculate lifetime annuity payments using life expectancy.
Basically, if you live as long as the actuaries expect, a lifetime annuity’s total distributions will equal all premiums paid in plus the growth earned by the annuity.
The formula used by the IRS to calculate taxable growth is based on the same idea – you estimate total lifetime payouts, subtract premium, and what’s left over is growth.
To make the calculation, you multiply your life expectancy (in years) by the annual amount paid out by the annuity. The product is the estimated lifetime distribution, which is reduced by the total premiums paid to figure estimated lifetime growth.
Dividing estimated lifetime growth by life expectancy gives you annual growth – the annual amount subject to income tax.
If the annuity pays out more than once per year, you simply divide annual growth by the number of payments per year to determine the taxable portion of each payment.
An Important Caveat
There’s an important caveat to keep in mind when considering the calculation – you cannot receive more premium back than what you actually paid in.
So, when you reach your life expectancy, the entire premium will have been paid back, and any further distributions are therefore taxable income.
On the other hand, if you don’t reach life expectancy, any unreturned premium remaining is deductible on your final income tax return.
The above formula assumes that the regular annuity payments will always be in the same amounts.
With a traditional lifetime annuity growing at a fixed contractual rate that’s more or less what happens.
However, variable and indexed annuity payments fluctuate based on investment or market performance.
For lifetime annuities without fixed distribution amounts, the IRS uses an alternate method based on annualized basis. Dividing total premiums by life expectancy (in years) yields an annuity’s annual basis. The amount by which payments received in a given year exceed annual basis is the taxable portion.
If an annuity pays monthly, divide annual basis by twelve to determine monthly basis.
As an example, let’s say you purchase an immediate indexed annuity with a premium of $60,000, and your life expectancy is twenty years. The annualized basis is $3,000 ($60,000 ÷ 20 years), and the monthly basis is $250.00 ($3,000 ÷ 12 months). If the annuity pays out $300.00 in July, the amount attributable to taxable growth is $50.00 ($300 – $250).
Because taxable growth is spread out over several years, annuity payments allow for a lower overall tax bill by avoiding the risk of a large lump sum bumping you up to a higher bracket.
Early withdrawals do not enjoy the same benefit. Instead the IRS uses LIFO (last-in, first-out) accounting, assuming that interest and earnings are paid out first and premium last. A complete surrender and termination of an annuity contract is taxed along the same lines, with the surrender value reduced by the total premium to determine the taxable portion.
Early withdrawals from a qualified annuity may also result in a tax penalty if the withdrawal is made before age 59.5. There are exceptions if the early withdrawal results from death or disability, or if the withdrawn amount will be paid out in substantially equal payments over the annuitant’s lifetime.
Nonqualified annuities are not subject to an early withdrawal tax penalty, but individual annuity contracts may have early withdrawal and surrender fees charged by the insurance company. Most contracts phase out the fees after the first few years.
Generally, when you elect to cash out an annuity or permanent life insurance policy for a lump sum payment, you owe income taxes for the policy or annuity’s growth for the tax year during which the surrender occurred.
However, Internal Revenue Code §1035 includes a special provision allowing a taxpayer to convert cash value from an existing contract toward a new one, without realizing any current gains.
Known as a “1035 Exchange,” the IRS rule lets you swap one annuity for another, or trade an existing whole life or other permanent life insurance policy for an annuity or a new policy.
You might want to swap an existing annuity for a contract with payment terms or a growth structure better suited to your present situation – or to obtain an annuity compatible with an asset-based long-term care strategy.
Likewise, it might make sense to trade a whole life policy for an annuity if your need for life insurance coverage decreases upon reaching retirement age.
In either above scenario, a 1035 Exchange would facilitate a tax-free swap.
Tax Basis of New Policy
When you execute a 1035 Exchange, the new policy or annuity inherits the prior contract’s tax basis.
For example, if you have a whole life policy with a $25,000 cash value and a $20,000 tax basis, you could execute a 1035 exchange to acquire a lifetime annuity using the insurance policy’s cash value to fund the annuity’s premium.
The exchange wouldn’t result in any immediate tax liability, and the annuity would inherit the whole-life policy’s $20,000 basis.
By way of comparison, if you surrendered the whole life policy, you would owe income taxes on the $5,000 growth, due on the tax return for the surrender year.
The tax bill would decrease the cash available to fund the annuity and, consequently, reduce the size of the annuity’s distributions.
A traditional lifetime annuity stops paying upon the annuitant’s death and therefore is not included within his or her taxable estate.
However, modern annuities commonly come with provisions allowing for inheritance, in which case the annuity’s value may be included in the estate like other financial assets.
If an annuity is inherited, heirs can cash out and pay the taxes due for the growth or accept the annuitized payments.
For a deferred annuity that has not begun paying, the heir can choose between a lump sum, a distribution schedule of no longer than five years, or annuitized payments over the heir’s lifetime.
If the decedent was already receiving payments, distributions to the heir cannot be extended longer than the schedule previously in place.
Annuity taxation can be complicated. It is important you have a good grasp of how an annuity can benefit you and what type of annuity would be best, based on your specific needs, goals and objectives.
For more answers to your annuity questions, please check out the links in this article which will take you to our numerous other annuity articles.
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