Understanding Taxation of Annuities
All annuities enjoy tax-deferred growth. Unlike a CD or an investment account that incurs taxable gains and losses every year, an annuity grows without tax until the money is taken out.
This tax-deferred treatment allows earnings to grow and compound exponentially over time. That said, while you may be deferring your tax obligation now, this doesn’t necessarily equate to tax advantages later. Your annuity income will be subject to tax down the road.
The tax treatment of the payment that comes out of your annuity depends on a variety of factors. One the of the first to clarify is in regards to Secondary Market Annuities.
Secondary Market Annuities are period certain receivables backed by existing annuity contracts. Because these annuities are typically issued in conjunction with structured settlements as a result of personal injury settlements, many of the rules on this page such as the 59 1/2 early withdrawal penalty, do not apply. Please consult the page on Secondary Market Annuities and Taxes.
As to newly issued annuities purchased from insurance carriers, these fall into to main categories:
First- Qualified Annuity or Non-Qualified Annuity?
For federal tax purposes, newly issued annuities fall into two main categories- qualified or non-qualified.
Qualified annuities are typically purchased through either an employer-sponsored retirement plan such as a 401K, or in an Individual Retirement Account (IRA). In both cases, the money used to purchase the annuity is qualified, or pre-tax.
If an annuity is purchased in an employer-sponsored retirement plan, the premiums paid are typically plan contributions and usually not included in an employee’s income. But, if an annuity is purchased in an employer-sponsored Roth vehicle such as a Roth 403(b), then the annuity premium is included in the employees’ income.
Non-qualified annuities are generally purchased by individuals using after-tax dollars. This means that the contributions to a non-qualified annuity are not deductible on the individual’s tax return.
Gains, dividends and interest credited to an annuity incur no taxes until withdrawn. The earnings are tax-deferred and grow and compound, and can be reinvested to help accumulate assets for retirement.
In addition, assets sold or turned over from one investment option to another inside an annuity contract do not incur a current tax liability. This is a major advantage over taxable investments which incur taxes when transferring from one position to another.
Taxes on Income From Your Annuity
The tax that is due on the income payout depends on if the annuity was acquired with qualified funds or non-qualified funds.
In the case of a qualified annuity, payments withdrawn from a contract or from the IRA that holds the contract are typically treated as a distribution. Note however that annuities held by individuals inside of self-directed IRAs, such as Secondary Market Annuities, will only incur taxes when the IRA custodian is directed to distribute funds. That means you can own an income annuity that pays into your IRA, but you can choose when to take money out of your IRA and incur taxes.
With an annuity purchased with after-tax dollars, only a portion of the income payouts from the annuity will be considered taxable. In this case, the portion of the income payout that represents the gain will be taxable. Similarly, the portion of the income payout that represents a return of the original contribution will be tax-free.
Note that income payments from an annuity – lifetime or period certain-have different tax treatment than withdrawals from an annuity. We’ll detail this more in a moment.
But in either case, income payments or withdrawals, gains are taxed at ordinary income rates, not as capital gains. When you withdraw a lump sum from a deferred annuity, you will owe income tax on all of the earnings that are over and above your contribution.
Penalty Tax on Annuity Income Under 59 /12
Congress designed the taxation rules in newly-issued annuities to favor deferral and to encourage long-term retirement savings. For this reason, withdrawals made before age 59½ may incur a 10% tax penalty on any taxable income taken, in addition to income taxes due on that amount. IRAs and 401K have similar early-withdrawal penalties.
Now, just as with IRAs, there are several exceptions to the 10% penalty. There are provisions for hardship and for the contract owner’s death or disability, so be sure to consult your own advisor.
A special note is warranted here again about Secondary Market Annuities– these receivables can be acquired by anyone of any age and without early withdrawal penalties. These period certain receivables are backed by existing and in force structured settlement annuities which were issued in conjunction with a personal injury settlement, and thus are not subject to early payout tax rules of newly issued primary market annuity contracts.
Understanding Last In First Out (LIFO) Annuity Taxation
For partial withdrawals or surrenders from newly issued non-qualified annuities, taxes are due on the “interest and earnings first.” This is also known as ‘Last In First Out’ or LIFO accounting- the last -or most recent- dollar of interest received into the contract is considered to be the first dollar taken out and taxed.
For example, if you invested $100,000 in an annuity and have a current account value of $150,000, the first $50,000 withdrawn is taxable. The remaining $100,000 is not taxed when it is withdrawn as it is a return of principal. Withdrawals are fully taxable until all interest and earnings are withdrawn, and then the remaining principal then is taken out without tax.
Once again, this tax treatment of “interest and earnings taxed first” underscores that annuities are long-term savings and retirement income vehicles. Congress granted annuities the advantage of tax deferral, but tempered it with the requirement to withdraw income first.
This LIFO taxation rule would apply to partial surrenders or partial withdrawals from annuity contracts- read on below for different rules on on annuitization or lifetime income streams, or for ‘substantially equal’ period certain payments.
Note, certain different rules may apply to tax-qualified annuities acquired in plans where non-qualified dollars were included in the premium. Talk to you plan administrator for specific to your situation.
Taxation of Annuity Income Payouts
A typical annuity owner has a number of income payout options. Previously we discussed partial withdrawals taxed on a LIFO basis.
But the basic rule for annuity income payouts, as opposed to withdrawals or partial surrenders, is that both the initial premium and the accrued interest are returned in equal installments over the payout period.
To use our example from above, if the initial premium was $100,000, and the account value is now $150,000, and the owner elects a 10 year payout schedule of $15,000 per year, $10,00 of each annual payment is tax free return of basis, and $5,000 is income taxed at ordinary tax rates.
This concept is known as an ‘exclusion ratio’. The taxable portion of each payment is equal to the excess of the payment over the “exclusion amount” or the initial premium
This exclusion ratio is most easily demonstrated with Secondary Market Annuities where the purchase price acquires a fixed and definite future payment. For example, this case from current inventory has an exclusion ratio of 64.78%.
American International Group –
$67,629.97 purchase price – 4.440% yield – $104,400.00 total payout
– 261 monthly payments of $400.00 starting 02/04/2019 ending 10/04/2040
For each $400 monthly payment, 64.78% or $259.12 is return of principal and $140.88 is taxable interest. You can find the exclusion ratio on the amortization schedule which is accessible on each case on our Secondary Market Annuities Inventory Page
Exclusion Ratio and Lifetime Income Contracts
When converting an annuity account balance into lifetime income, the exclusion ratio is calculated off the owner’s expected lifespan. Take for example a male age 65 with an investment of $100,000 in an annuity contract paying $10,000 per year. Per the IRS mortality tables, the owner has a life expectancy of 20 years, so 1/20th of the investment, or $5000, would be considered return of principal in the annual income amount.
As there are a wide range of income options, variable gains, and continuing account accumulation options even during payout among today’s annuity offerings, this is just a general rule. Part of the expertise available to you when working with us at DCFAnnuities.com is to help analyze the tax ramifications when selecting the right annuity for your needs and ensure that you and your tax advisor have all the information needed to make an informed decision.
Taxes Consequences When Replacing an Annuity
In some cases, an annuity that was purchased in the past may no longer fit in with your current or future goals. Because of that, it could make sense to replace it with another annuity that more closely correlates with your objectives.
Replacing one annuity for another is referred to as a 1035 Exchange. Under a 1035 Exchange, the IRS will allow you to replace one annuity for another without you incurring income taxes.
In doing so, however, there are several rules that must be followed. First, the funds must pass directly from one annuity to the other in order to retain this positive tax treatment. In other words, you cannot take receipt of the funds – even if you use those funds to purchase a new annuity.
In addition, both the owner and the annuitant on the new annuity must be the same as the owner and annuitant on the old annuity. (Although these may be changed once the 1035 Exchange has been completed).
Note that Secondary Market Annuities can not be used in 1035 exchanges for the simple reason that the payments are already issued. As there is no new annuity contract issued, there is no way for the issuing annuity companies to apply the premium from the relinquished annuity.
How to Maximize Your Future Income
Today’s annuities can come with a long list of features and benefits. But while these products can essentially allow you to “customize” an income strategy to better fit your objectives, these financial vehicles require a certain level of expertise to find the right fit.
DCFAnnuities.com cuts through this confusion so you know exactly what you’re getting and what you can anticipate now and in the future. With access to a wide range of annuities as well as other safe money alternatives you can rest assured that your principal is protected from market volatility, while at the same time continuing to grow.
At DCF, we crunch the numbers and do the math, so you can retire right. Contact Us to find out more about how you can maximize the amount of spendable income you have in retirement- because the decisions you make today can have an impact on how much you’ll have available to spend tomorrow.