Taxes and Annuities

The main appeal to most annuities is tax deferral. What tax deferral means is that you do not pay taxes on your investment build-up until you receive your payout. The reason it is so popular is because it gives you control over when you pay taxes. A strategy many annuity owners use is to take distributions at retirement when other sources of income are less and their income tax bracket is lower.

Annuities have three phases: purchase payment, growth period (accumulation phase) and distribution phase. The following is the tax implications of each phase, as well as what happens at death.

Purchase payment

Whether you get an immediate or deferred annuity, your purchase payment is made with after-tax dollars. Other retirement investments, such as employer-sponsored 401(k) contributions are made with pre-tax dollars. Many advisors suggest maximizing contributions to a 401(k) before an annuity is considered. Annuities do have a favorable attribute over other like other long-term, tax-advantaged investments; you can put as much money into annuities as you wish. There are no limits to the amount you can contribute to an annuity. This is a sharp contrast to the $16,500 limit on 401(k) contributions.

Growth (accumulation) phase

While your annuity investment grows, it remains untaxed. The longer your money remains in the accumulation phase, the more growth you will enjoy. If you have a variable annuity, you are allowed to move your money to different investment options without being taxed. If the market in a particular sector is down, you can reallocate your funds to a sub-account with greater growth potential. Your insurer may require a minimum amount to be kept in a money market fund to cover annuity expenses, and may restrict the number of transfers made within a certain period.

Distribution Phase

This is the period in which you receive income payments from your annuities. The income you receive is calculated by the insurer and is based on your age, gender and purchase amount. Your payments consist of two parts: return of principal and interest. Return of principal is equal to your purchase payments (minus expenses). Interest is the investment growth you enjoyed while the money was invested. The interest is taxed at an ordinary income rate. As long as you purchased the annuity with after-tax dollars, the return of your initial investment is tax-free.>Your payments can be made in a lump sum or as a series of scheduled payouts over a specified time or throughout your lifetime. No matter how you receive your payments or when, you are going to have to pay taxes.

Lump-Sum Distribution

On a lump-sum distribution, you will be taxed only on your investment growth. The way it is calculated is simply to take the difference between what you paid into the annuity, and its value when it is paid back. For example, if you invested $100,000 and over twelve years it grew to $125,000, you would be taxed only on the growth of $25,000. The tax rate is your ordinary income rate in the year of distribution.

Annuitization

The term annuitization refers to the schedule of payments made to you by the by the insurance company. For tax purposes, part of each payment is considered a return of your investment, and the other part is your earnings. As previously mentioned, you are only taxed on the part that is considered earnings. The tax rate assessed is based on your ordinary income tax rate.

Variable annuities work slightly differently because of the fluctuation in amounts paid in each scheduled payment. Variable annuity payouts are based on the investment growth of the sub-accounts where your funds are invested. The taxable amount can be calculated by dividing your investment by the time frame during which you expect to receive payments.

Withdrawals

Throughout both the growth and the distribution phase, you may have a need to make withdrawals. A withdrawal is determined to be any amount distributed from the annuity that is not part of the annuitization process.

The tax-treatment for withdrawal has evolved over time. Investments made after 1982 are taxed on a last in, first out basis. What this means is that a withdrawal made out of your post-1982 annuity would be considered 100% earnings, not a return of your original investment. You would be taxed the ordinary income rate for the entire withdrawal amount. Also, if that withdrawal is made before you turn 59 ½ years old, you will also be assessed a 10% early withdrawal penalty by the Internal Revenue Service.

At Death

Whether your annuity passes to your heirs depends on the type of annuity you bought.

If you bought a life-only contract, then nothing passes to your heirs. Payments stop when you die.

If you had a joint-life annuity, and you die, the contract will continue to payout to your spouse. Your spouse will pay ordinary income tax rates on the investment gain until the entire investment in the contract is recovered.

If you had a fixed period annuity (for example, you would receive payments for 20 years), and you died before that time elapsed, then the remaining payments will be made to your beneficiaries. The person receiving the remaining payments will pay ordinary income tax on all earnings.

If you die before receiving any payments at all, the money will go to the beneficiaries who have been designated as such in the contract. The beneficiaries will be taxed on the earnings at ordinary income tax rates.