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Annuity TaxationAre annuities taxable? The short answer is yes. However, the long answer is much more nuanced as you will discover in the following article covering the taxation of annuities.

Taxation of Annuities

When you buy an annuity contract, you’re paying the insurance company a large lump-sum payment up front in exchange for the right to receive periodic pay-outs over an extended term, often the rest of your life.

Because annuities earn interest, if you reach your life expectancy (or when you reach the end of the term for non-lifetime annuities), you will have received substantially more money back from the insurance company than you paid in the beginning.  The difference – i.e. the amount representing the annuity’s growth – is taxable income.

“Deferred Growth”

It’s important to note that the growth earned on an annuity isn’t taxable right away.  Due to an attractive feature called “deferred growth,” you don’t owe any taxes on an annuity’s earnings until you actually receive the money.

Deferred growth allows the earnings to build into even more earnings, like compound interest.

In the case of a deferred annuity, for example, the balance of the deferred annuity steadily grows during the entire deferral period without any current tax liability.

With variable annuities, you can even move money around between investments without incurring any taxes, up until you begin receivcing distributions from the variable annuity.

The idea is that the IRS wants you to use the growth to continue saving for retirement – that’s what annuities are designed for.  So, you pay taxes when you receive the money in the back-end but not as the annuity grows.

There’s an exception if the annuity owner is not a “natural person,” in which case growth is taxed as it accumulates.

And, the exception to the exception is that deferred growth is permitted if the owner is a trust holding the annuity for a natural person’s benefit or an estate holding it after the original owner’s death.

For our purposes, though, the important take-away is that earnings are taxable income but not until you actually receive the money.

Taxation of Nonqualified Annuities

The point at which you start receiving money back from the insurance company is known as the “annuitization phase.”

The annuitization phase is simply the time period when the insurance company is paying you (as opposed to the “accumulation phase” when you are paying the insurance company).  You receive payments either monthly, quarterly, or annually, with each payment composed of both growth and “return of premium” (i.e., the repayment of your initial investment).

Assuming you have a “nonqualified annuity,” meaning it was purchased with after-tax money, you’ve already paid taxes on the premium, so you don’t get taxed on that portion of the payment.  But you do pay taxes on the growth.

This raises an important question:  how do you know which portion of an annuity payment represents growth and which is just the insurance company giving you your initial investment back? After all, if you’re receiving payments for life, you can’t know for certain the total payment amount you will ultimately end up with.

With this uncertainty in mind, the IRS developed a formula to determine the portion of an annuity’s yearly pay-out deemed to be taxable growth. Any payments received above that amount are considered untaxed return of premium.

To calculate taxable growth, you multiply your life expectancy by the amount of annuity payments you will receive each year.  The result is the total lifetime payments that the IRS expects you to receive from the annuity.

Next, you subtract the premium (your initial investment) from the lifetime payment amount.

The result is the annuity’s anticipated lifetime growth.  If you divide the lifetime growth by your life expectancy, you’re left with the annual taxable growth.  That’s the amount you pay taxes on each year.

An Example

It’s easier to digest when you consider an example, and we’ll use nice round numbers to keep it simple.

Let’s say you purchased an annuity for $200,000 that pays out $1,000 per month, and your life expectancy is twenty years.

Each year, you’ll receive $12,000 in payments which, over twenty years, ends up being $240,000.  Taking out the $200,000 premium leaves $40,000 in estimated growth over the life of the annuity.  That works out to $2,000 in taxable income per year out of the $12,000 annual payments.

So, what happens if you exceed your life expectancy or don’t meet it? 

The amount attributable to return of premium can never exceed what you actually paid for the annuity.  So, if you live past your life expectancy and have already received all of the after-tax premium back from the insurance company, the future annuity payments are comprised completely of taxable growth.

Conversely, if you die having only received half of the premium back, and the annuity does not make any postmortem payments (i.e. annuity death benefit), the remaining unreturned premium is deductible from your income for your final tax year.

Taxes for Variable Annuities

The above formula works well for fixed annuities because you can predict the annual payment amount with reasonable certainty.

However, variable annuities and structured settlement annuities are linked to investment performance and are therefore not as predictable.

To determine annual growth for annuities with varying pay-outs, you first need to know your annualized basis (the yearly pay-out attributable to return of premium).  Then, anything over that is taxable growth.

Annualized basis is calculated by dividing premium by life expectancy.  Using the figures from our example above, the $200,000 premium and 20-year life expectancy result in an annualized basis of $10,000.

If the annuity pays monthly, you divide $10,000 by twelve months, resulting in a monthly basis of $833.33.  Thus, any amount by which the monthly payment exceeds $833.33 is taxable growth.

With a $1,000 payment, this equates to $166.67.  If the payments stay consistent over twelve months (which would be unlikely with a variable annuity), you again end up with $2,000 in taxable income.

Taxation of Qualified Annuity Payments

The previous examples apply to nonqualified annuities, but an annuity can also be purchased as part of a retirement plan using pre-tax money, in which case it is a “qualified annuity.”  Because no income taxes have been paid on the premium, all payments from a qualified annuity are taxable income when received.

If after-tax money has also been contributed, the taxable income for each payment is reduced proportionally according to the ratio of pre-tax to after-tax money.

Like IRAs and 401k’s, qualified annuities are subject to annual contribution limits, and, once you reach age 70.5, you must take out an annual “required minimum distribution.”

Nonqualified annuities are not subject to required minimum distributions or contribution limits, though insurance companies place caps on contributions.

Income tax due for annuity payments, whether qualified or nonqualified, is calculated using standard income tax rates applicable in the year during which the money is received.

A 3.8% Medicare tax may also be owed if your adjusted growth income exceeds $250,000 if married filing jointly, $125,000 if married filing separately, or $200,000 if you are not in either category.

Early Annuity Withdrawals

Along with income tax, early annuity withdrawals may also result in tax penalties and surrender fees.

If a withdrawal is taken as one lump sum, you determine the taxable portion by subtracting the after-tax premium from the withdrawal amount.

If the lump-sum is less than the premium, you can claim the difference as a loss on an itemized return.  Because they have no after-tax premium, any withdrawal from a qualified annuity is taxable income.

LIFO

Unlike cash value life insurance which typically uses a FIFO (First In First Out) model, partial withdrawals from an annuity follow the “interest and earnings first rule,” or, for accountants, Last In First Out (LIFO).  This means the IRS assumes that the first money withdrawn from an annuity is growth and, correspondingly, the premium comes out last.

So, if you withdraw $15,000 as part of your retirement income from an annuity purchased for $100,000 and now valued at $110,000, the first $10,000 of the withdrawal is taxable income.  And the remaining $5,000 is untaxed return of premium.

Similar to 401k withdrawal rules, early withdrawals are also subject to a 10% tax penalty if made before age 59.5.

However, the penalty does not apply if the withdrawal occurs due to death or disability, or is paid in substantially equal payments over the annuitant’s life expectancy, or in the case of immediate annuities.

The insurance company may also charge contractual surrender fees depending upon how early the withdrawal is made.

Estate Taxes on Annuities

If an annuity is inheritable, its present value is included within the deceased annuitant’s estate and potentially subject to estate taxes.

However, the estate tax exemption for 2018 is $11.18 million, so the vast majority of estates do not qualify for the tax.  To the extent an estate, including an annuity, exceeds $11.18 million, the excess is taxed at the estate tax rate of up to 40%.

The more practical concern for most taxpayers is the income tax consequence to beneficiaries on the annuity and any death benefit.

The IRS does not want heirs to defer annuity gains indefinitely, so the tax code limits further deferral depending upon whether death occurs during accumulation or annuitization.

If an annuity owner dies before payments have begun, the heir must either cash out the annuity as a lump sum, distribute the total within five years, or annuitize the payments over the heir’s lifetime.

If payments started prior to death, the heir cannot defer the pay-out beyond the distribution schedule in place at the time of death.

In either scenario, the heir owes income tax on any earnings paid out, but growth can continue tax-deferred during the period of permissible deferral.

Now…

We know that we’ve gone over a lot of information here, and for most having just a “vague” understanding is adequate because ultimately they’re going to have their tax professional help them out with all of this.  Which is why, we tried to keep things as “uncomplicated” as possible.

Because as…

We all know, taxes can be quite complex especially as ones assets and investments grow.  Which is why, we here at I&E always advise anyone to first consult with their financial adviser or tax consultant prior to making any financial decisions as well as just give us a call and see if we might have a few options you might want to consider as well.

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