The tax treatment of income from an annuity is an important factor that should be considered when evaluating product options to support a retirement income plan. Other tax considerations would also apply with regard to death benefits and the impact on an estate plan. (Read more about the different types of annuities and how they work.)
Ultimately, the most important benefits from an annuity are safety, tax deferral and guaranteed payments. No other investment vehicle will continue making payments without management or risk, even if you live well past retirement age. Either your existing capital gets depleted, or you have to continue managing, with some risk, an investment portfolio. With an annuity, the accumulation and distribution phases of investment are merged together and what you get is an investment vehicle which offers substantial and continued returns with relatively low or no risks in the long term.
It is to be noted that there are various kinds of annuities, and numerous insurance companies which offer annuity products with varying rates of return, different administrative and annual charges, and differing corporate policies, annuity surrenders and transfers. Each annuity and each company has its own set of advantages and features. The choice of annuity and company most suitable for you, along with the benefits that best apply to your specific situation, should be decided by a competent financial advisor.
Deferred vs. Immediate Annuities
There are two phases associated with an annuity contract:
1) deferral phase – when investments can grow on a tax-deferred basis and can be liquidated at some point in time given certain rules and restrictions, and
2) income phase – or annuitization phase – where the assets in the contract are converted into a lifetime stream of income2 – similar to other sources of lifetime income such as a pension or Social Security.
Although deferred annunities allow you to delay paying taxes, they do not eliminate taxes altogether.
Income taken from a deferred annuity, such as a variable annuity or fixed index annuity, is typically taken in the form of a systematic withdrawal from the investment account(s) within the contract. Sometimes the level or amount of withdrawals can be guaranteed for a lifetime without having to annuitize the contract with the election of a living benefit rider – such as a guaranteed lifetime withdrawal benefit (GLWB). Alternatively, anyone wishing to purchase an annuitization guarantee based on today’s interest rates and mortality factors will buy either an immediate income annuity (SPIA) or a deferred income annuity (DIA).
What’s really important to understand is the difference between qualified and non qualified annuities.
- Qualified Annuity – A financial product that accepts and grows funds, and is funded with pre-tax dollars. “Qualified” is a descriptor given by the Internal Revenue Service (IRS) to indicate that the qualified annuity may be eligible for tax deduction. When a distribution is made, it is subject to income tax. Qualified annuities are often set up by employers on behalf of their employees as part of a retirement plan. (Source: Investopedia) No taxes are paid on the assets as long as the money stays within the qualified product. However, anytime you take assets out, whether it is a lump sum or a systematic withdrawal, all of the monies received are fully taxable as ordinary income. In the case of annuities, the taxation as ordinary income from a qualified contract is the same regardless of whether it is taken during the deferral phase as a withdrawal or the annuitization phase as a payout.
- Non Qualified Annuity – An annuity funded with after-tax dollars. While distributions from a qualified annuity are taxed as income, distributions from a non-qualified annuity are not subject to income tax in their entirety. Qualified annuities are often set up by employers on behalf of their employees as part of a retirement plan. Deposits into a nonqualified contract are usually made with funds that have already been taxed to the client. These funds are considered the principal and are called the “cost basis.” When the client takes money out of the contract, the cost basis (or principal) is the portion that is not subject to income tax. Beyond that there are some differences to consider between deferred and immediate annuities.
Nonqualified Immediate Annuities
When you buy a nonqualified income annuity, you give an insurance carrier money (the premium) in return for a stream of guaranteed income that will start within the next month to 12 months or possibly deferred anywhere between two to 30 or more years. Part of this income stream would be considered the cost basis and is not taxed, while the other portion, which is considered earnings, is taxed as ordinary income.
What is an “exclusion ratio”? – Amount of each payment that will not be taxed. It is determined by dividing your investment in the contract by the total amount you expect to receive during the payout period.
Exclusion ratio = Total Investment in Contract / Total Amount Expected to Receive During Payout
Below is an example for illustration purposes.
Let’s take a 65-year-old male with $100,000 to deposit in the SPIA with five years certain. Today, this would provide him with an income stream of $585 per month or $7,020 per year. The IRS estimates his life expectancy at 21.9 years, based on the Uniform Lifetime Table. To find how much is excluded from taxes (i.e., the exclusion ratio), we would take the $100,000 (cost basis) and divide it by $153,848 ($7,025 of annual income x 21.9 life expectancy), and get an “exclusion ratio” of 65.0%. The exclusion ratio is the portion of the income payment that the IRS considers as a return of the client’s principal and therefore is not subject to tax. In this case, that works out to having $4,566 of the $7,025 per year excluded from taxes and the client would have to pay ordinary income tax on the remaining $2,459 each year. Once the client recovers all of his cost basis (basically the original $100,000 after 21.9 years), then any income payment going forward will be fully taxed as ordinary income. (Source: Annuity Outlook Magazine)
The same process would apply to a DIA, but because DIAs typically generate a higher payout amount in return for a delayed income start date, a larger portion would be taxable. For the same 65-year-old male with $100,000, the monthly income stream from a DIA with a 10-year income deferral would be $1,233 per month or $14,796 per year.3 At the age of 75, his life expectancy would be 13.9. Therefore, the amount that would be excluded from taxes would be $100,000 (cost basis) divided by $205,664 ($14,796 x 13.9). This would equate to an exclusion ratio of 48.6%. Again, once the cost basis is fully recovered over time, payments would then be 100% taxed as ordinary income. (Source: Annuity Outlook Magazine)
Nonqualified Deferred Annuities
Any withdrawals (or lump sums) taken from a deferred annuity (VA, FIA, or fixed) – during the deferral phase – would be taxed on a last-in, first-out (LIFO) or “earnings first” basis. This simply means that earnings are taxed first, as ordinary income, up to the amount of the withdrawal. At some point in the future, if withdrawals exceed earnings in the contract, then those additional withdrawal amounts are considered tax-free until the original investment (or premiums) has been depleted.
LIFO, or earnings-first, tax treatment of withdrawals would also apply if a GLWB (guaranteed lifetime withdrawal benefit) is in effect. However, if the account value were to ever hit $0 at some point in the future, any guaranteed withdrawal received at that point forward would be 100% taxable as ordinary income. This is because the insurance company is technically transitioning the contract into the annuitization phase to support the GLWB guarantee going forward with essentially a “premium of $0” coming from the client, resulting in an exclusion ratio of 0%.
If you choose to trigger the annuitization phase within a deferred annuity contract, the tax treatment would be similar to that of an immediate annuity through the use of an exclusion ratio. Tax laws now allow to partially annuitize deferred annuity contracts and enjoy the advantages of both the tax-free growth in a deferred account and exclusion ration treatment for the annuitized portion. This is known as splitting a deferred annuity.
Below is an example to illustrate:
Let’s say you invest $100,000 into a deferred annuity that is now worth $200,000 and you want to annuitize $100,000. Half the original cost basis, $50,000, would transfer over to a supplemental immediate annuity contract held by the same carrier and exclusion ration treatment would take effect. Ultimately you would still pay the same amount of tax, but you would now be able to distribute the tax burden by not paying all the tax up front (via LIFO).
Finally, the tax treatment of income from an annuity needs to be carefully considered in the landscape of everyone’s particular financial and tax circumstances. A competent financial advisor should be able to help you understand how the tax treatment of income from an annuity will affect your overall financial situation.