Chapter 4 - Tax

Stretch IRAs

The SECURE Act, which passed in December 2019, changed this provision for non-spousal IRAs. One of the most important aspects for life insurance and annuity contracts (both non-qualified and tax-qualified annuity) is the ability of the contract owner to name or designate a beneficiary, and to have the ability to change the beneficiary, if needed. The beneficiary designation determines who receives the proceeds of the life insurance or annuity. Likewise, for any retirement plan asset such as an IRA, 401(k), 403(b), a 457 deferred compensation plan, defined benefit pension plan, or Keogh plan, the beneficiary designation is absolutely critical to determine who receives the tax-qualified assets at the death of the account owner. This is especially important because these accounts are typically established when an employee is originally hired and, unless they are updated periodically, many life-event changes may occur during the course of a working career. The SECURE Act encompasses a lot of changes to retirement assets, including changes to the rules for distributions of inherited retirement assets. We now have two sets of designated beneficiary rules to follow based on the answer to these questions: Did the contract owner die on or before December 31, 2019? Did the contract owner die on or after January 1, 2020? If the contract owner died on or before December 31, 2019 - the previous stretch IRA rules still apply. Before the SECURE Act took effect on 12/20/2019, a contract owner could (generally speaking) name anyone as a beneficiary—a child, a grandchild, etc. That beneficiary would have the right to inherit retirement plan assets and take distributions over his or her life expectancy. These "stretch" rules allowed tax deferral on the original plan assets to continue for more years, stretching the tax-qualified account over a longer period. This process resulting in greater income being generated from the account and postponed or reduced any required minimum distributions. If a tax-qualified account named several beneficiaries, each beneficiary (independent of the others) could decide to take the inherited amount all at once (and pay the tax) or stretch it over his or her life expectancy. If the owners of tax-qualified retirement accounts with non-spousal beneficiaries died on or before December 31, 2019, the beneficiaries are allowed to use the stretch-strategy. Like the original owner, these beneficiaries will generally not owe tax on the assets in the IRA until they receive distributions. In the past, these benefits could even be stretched out over several generations, with first-generation beneficiaries leaving their inherited accounts to second-generation beneficiaries. If the first-generation beneficiary was very young—a grandchild or great-grandchild—the impact could be spread over decades. If a trust is named the beneficiary of a retirement account, the trust beneficiaries do not have the ability to stretch the IRA over their life expectancies. There may be reasons to name a trust as a contingent beneficiary of a retirement account, and professional tax and legal advice should be sought before making any beneficiary decision in the short term. If the contract owner died on or after January 1, 2020, a new 10-year rule applies. Under the SECURE Act, the only beneficiaries with special provision to "stretch" required distributions are called Eligible Designated Beneficiaries (EDBs). EDBs include the deceased account owner's spouse, minor child until the age of majority, a disabled or chronically ill individual, and any individual or not more than 10-years younger than the deceased account owner, such as a younger sibling. Once a minor child reaches the age of majority in his or her state, the 10-year rule applies. Other than those categories of beneficiaries, the non-spouse beneficiary must deplete the inherited account value back to zero by the end of the 10th year following the year the original account owner died. In addition, any successor beneficiary of the Eligible Designated Beneficiary falls under the 10-year payout rule.

Payment of Premiums

A key distinction of the non-qualified annuity is that it is purchased using after-tax dollars. The premium paid for the non-qualified annuity, along with any subsequent premiums, establishes the cost basis for the non-qualified annuity. In simple terms, the cost basis equals the total amount paid for an item such as a building, a home, a computer for use in business, or a financial product such as a deferred annuity. Basis is the starting point for establishing gain or loss.

Deficit Reduction Act

As a result of the Deficit Reduction Act, distributions made from non-qualified annuities may be used to pay premiums for Long Term Care Insurance or expenses incurred with nursing home care. This is a form of 1035 exchange, where the cash value of the annuity pays premiums on a tax-qualified Long Term Care Insurance policy. The huge potential tax break is that part of the annuity cash value is gain that otherwise would be income taxable. Here is a way it can be withdrawn and spent without being a taxable event.

Exception

If non-deductible contributions were made to an IRA, Roth IRA, or Roth 401(k), these accounts generally have a basis that is non-taxable. They are established with after-tax contributions, not tax deductible deposits. They grow tax deferred and the eventual distributions will be tax-free under certain conditions.

Tax Deferral & Annuities

Individual investors are allowed to defer taxes on qualified accounts while working, and then pay taxes when the money is withdrawn during retirement. If ordinary tax rates increase in the future, these individuals may pay higher tax rates in retirement than during working years, although it is widely held that by the time of retirement, individuals or couples settle back into lower tax brackets, as they live off retirement investments with fewer expenses than earlier in their lives.

Defined Contribution Plans

Since the 1960s, the popularity of defined benefit plans has diminished. Although pension plans are still around and new defined benefit plans are being added each year, the rapid growth and wide acceptance of defined contribution plans has outpaced pension plans. The clear trend is that defined contribution plans are currently growing faster than defined benefit plans. The 401(k) is the Most Widely Used Defined Contribution Plan It allows employees to defer a portion of their current income in a pre-tax savings account with the convenience of a payroll deduction. 401(k) plans must follow strict regulation concerning how much the highly compensated employees (usually business owners and key managers) may contribute compared to the non-highly compensated employees (rank and file workers). Under the SECURE Act, rules relating to the election of safe harbor 401(k) status changed (Section 103). The safe harbor notice requirement for nonelective contributions was removed. Employees are still allowed to make or change an election at least one time each year. Other rules also changed. In addition, Section 102 of the SECURE Act increases the cap for the automatic enrollment safe harbor after the first plan year. The increase went up from 10% to 15%. Employer Matching In some defined contribution plans, management will match employee contributions up to a certain dollar amount or percentage of employee income. This tends to increase rank and file employee participation - think "free money." This incentive provides an additional benefit for the highly compensated employees (typically the owners, or managers of the business) by allowing a higher level of participation and tax-deferred accumulation in the plan. Portability Portability is another advantage of 401(k) plans. For employees who change jobs, the ability to rollover 401(k) account values into a new employer's plan may offer the possibility of continuous growth. Even if a new employer's plan is not set up to receive money from a previous employer, the employee may rollover his/her 401(k) account to an IRA and continue the tax-deferred accumulation until retirement. Section 109 of the SECURE Act amended the following sections of IRC: 401(a), 401(k)(2), 403(b), and 457(d). If a lifetime income option is no longer allowed under a plan, the law now allows direct trustee-to-trustee transfers to another employer-sponsored retirement plan or IRA of lifetime income distributions or a qualified plan distribution annuity. This change applies to qualified defined contribution plans, 403(b) plans, and government 457(b) plans. Investment Choice Many employees in 401(k) plans enjoy selecting investments. Plans usually have a menu of ten to thirty mutual funds to choose from. Employees may reallocate investments among the various choices via telephone or computer access to their accounts. Employee investment choice has a distinct disadvantage. The employee bears 100% of the risk. During good times in the stock market when growth is positive, employees are usually happy about their selections. During bad years in the stock market when growth is negative and values drop, employees have no company backup and no safety net, other than the more conservative investment choices in the plan such as a money market or stable value account, or perhaps a bond account. The SECURE Act amended rules relating to 401(k) plans. Among the changes was the removal of the safe harbor notice requirement for nonelective contributions. Employees are still allowed to make or change an election at last one time each year. After Employment When an employee departs from the employer and continues to leave the funds in the old employer's plan, frequently the management fees which were paid by the former employer become a new expense to the ex-employee's 401(k) investment. A rollover to an IRA or new plan eliminates this expense. Loans Some plans include loans as a part of the 401(k) plan, which may allow employees to borrow up to half of the account value, up to a maximum of $50,000. These loans must be paid back according to a definite schedule; otherwise the loans are considered current income, and are taxable with 10% penalties (if younger than age 59½) added to the current taxes due. The SECURE Act amended Section 72(p) of Internal Revenue Code. Employers are now prohibited from making plan loans through credit cards and similar types of arrangements. Despite the popularity of 401(k) plans, most employees are currently unaware of a major issue that most plans have. In a majority of cases, existing defined contribution plans do not have a mechanism for taking withdrawals at retirement. Most plans suggest that participants rollover their account balance at retirement to an Individual Retirement Account (IRA). There are no guarantees that either required minimum distributions or systematic withdrawals from mutual funds will provide adequate retirement income for the retiree's life.

Before the Required Beginning Date (RBD)

The Required Beginning Date (RBD) for most tax qualified accounts is the year when the account owner turns age 72. RMDs previously began at 70 ½, but the age was raised to 72 following the December 2019 passage of the SECURE Act. In community property states, the spouse is usually the designated beneficiary of any qualified plan, annuity, or IRA. If the account owner dies before the RBD, the spouse may inherit the account and re-title it in the spouse's name. This allows the surviving spouse to continue the tax deferred accumulation in the account.

Taxation of Non-Qualified Annuities upon the Death of the Annuitant

An annuity is annuitant-driven when the payment of the death benefit to the beneficiary is made upon the death of the annuitant. The beneficiary generally has a 60 day window to make a decision and if the beneficiary does not elect within that window of time to take the proceeds as an annuity (if the contract allows this option), the proceeds will be considered "amounts not received as an annuity" for taxation purposes. The proceeds above the original investment in the contract (the gain in the annuity) are taxable to the beneficiary in the year of the annuitant's death. However, if the beneficiary is the surviving spouse of the annuitant, the spousal continuation option is not available. Spousal continuation is only available when the beneficiary is the surviving spouse of a deceased holder (owner).

Taxation of Qualified Assets at Death of Owner (Spousal Continuation)

Before the Required Beginning Date (RBD) After the Required Beginning Date

Key Annuity Advantage

Converting a deferred annuity to a guaranteed lifetime payout annuity will continue the annuity payments for a lifetime (single life or joint and survivor annuity). This is a unique advantage of receiving retirement annuity income payments and is the answer to the longevity risk and the fear that retirees may run out of money. Conversely, making systematic withdrawals, or taking annual required minimum distributions from an IRA will deplete the account value over time. This is especially true if the account is invested in riskier stock market accounts or when the stock market does not grow at a rate to replenish the prior year-end IRA balance. Even partial withdrawals from an unconverted deferred annuity will eventually reduce the account value. If partial withdrawals continue, the deferred annuity will eventually be depleted just like the IRA account. In fact, annuitizing a tax-qualified annuity may not only satisfy the required minimum distribution amount for that retirement asset, in many cases it will actually provide greater retirement income for life, even after paying the taxes, than a traditional IRA with RMDs. Net after taxes, the income from the annuity is usually greater.

Distributions Taxable in the Year Received

Distributions from tax-qualified annuities, IRAs or other qualified plans, prior to age 59½ are subject to a 10% penalty in addition to ordinary income tax. This tends to discourage the use of tax-qualified annuities and qualified plans as a short-term savings strategy. Distributions beginning at age 59½ are subject to current taxation without the 10% penalty.

Gifting a Non-Qualified Annuity

If an annuity owner gives an annuity as a gift, the owner may have to pay income and gift tax at the time of transfer. The contract owner must include as income the difference between the cash surrender value of the contract and the owner's investment in the contract at the time of the transfer. This does not apply to gifts or transfers between spouses or former spouses due to a divorce. The IRS requires transfers between former spouses to be made pursuant to a Qualified Domestic Relations Order (QDRO).

Income in Respect of a Decedent (IRD)

Income in Respect of a Decedent (IRD) is income that would have been received by the person who died if he or she had lived long enough to receive it. Unfortunately, if death occurs and this money is received by a beneficiary instead of the decedent, the monies are included in the gross income of the person who receives the income at the time of the actual receipt. It may be helpful to think of IRD as the final income tax on income due the decedent, but actually paid to someone else. Taxes must be paid.

Taxation Rules for Non-Qualified Annuities

Non-qualified annuity contracts are taxed under favorable rules according to Section 72 of the Internal Revenue Code.

Cash Value Accrual

The owners of non-qualified deferred annuities enjoy increasing account values each year without having to pay current taxes on the account growth. Cash accumulation value is determined without considering surrender charges and taxes are deferred until a future time when money is withdrawn from the annuity (when the account is annuitized). By comparison, non-qualified mutual funds are subject to income taxes and capital gains annually. A client may hold the same mutual fund for decades, but the portfolio manager will be buying and selling investments within the fund generating capital gains, receiving dividends from stocks, and perhaps interest from bonds. A 1099-DIV is mailed to mutual fund shareholders who receive a dividend or capital gain distribution during a given tax year.

Legislation Concerning Qualified Plans & Evolution of IRAs

Under ERISA and the Retirement Equity Act, pension plans provide for two types of survivor benefits: "Post-retirement survivor benefits provide payments to the spouse of a worker who dies after retiring, under what is called a "joint-and-survivor annuity." In most current plans, the choices are usually between the 50 percent option (the default choice) and more generous survivor forms, such as two-thirds, 75 percent or 100 percent of the retiree's pension. When a joint-and-survivor annuity is in effect, the size of the retiree's pension is almost always lower than it would be for an unmarried or single participant. The joint-and survivor annuity spreads retirement benefits over a longer potential time frame - over two life expectancies. The spouse of a newly retired worker must waive the automatic form in writing before the retiree can select another payment form." Pre-retirement survivor benefits provide payments to the spouse of a worker who dies prior to retirement.

Taxation of Non-Qualified Annuities upon the Death of the Owner

Annuities in Payout Status If an owner of a non-qualified annuity dies on or after the date that an immediate or deferred annuity has been annuitized, but before the entire interest in the contract has been distributed, the remaining portion must be distributed to the beneficiary at least as quickly as the distribution method that was in effect at the time of the owner's death. If the beneficiary continues to receive payments under the same payout option that was originally in place, the original exclusion ratio will continue to apply.

Amounts Received as Interest

Amounts received as interest means withdrawing the interest that has accumulated in a deferred annuity: for example, the principal remains invested with the life insurance company, but the interest is removed from the account.

Non-Spouse Beneficiary

A non-spouse beneficiary may transfer assets into an IRA in the name of the original owner for the benefit of the non-spouse beneficiary and will continue taking distributions, but over his or her life expectancy.

Taxation of Qualified and Non-Qualified Annuities

Annuities may also be classified as either "qualified" or "non-qualified." This distinction is critical to understanding how annuities are used in retirement and how they are taxed. Simply stated, a non-qualified annuity is one purchased with money that has already been taxed. A qualified annuity is purchased with money which has not yet been taxed as income. Why is this important? First, we need to delve into qualified retirement plans to set the stage for discussing qualified versus non-qualified annuities. The difference is not in the annuity policy itself, rather it is how the tax laws affect the amount that can be deposited, when and how much must be taken out, taxes and tax penalties.

Loans & Assignments

Policy loans are usually not allowed from non-qualified annuities. Certain tax-qualified accounts such as 403(b) accounts may allow loans from annuities if annuities are funding vehicles. Usually the maximum loan allowed is one-half of the account value, up to a $50,000 maximum. The loans must be repaid in regular intervals with payments of principal and interest over a five year period. Any assignment or pledge of any portion of an annuity contract's cash value is treated as a withdrawal from the contract. The tax treatment in this case is the same as it is for partial withdrawals from annuities.

Selling a Non-Qualified Annuity

The gain in the contract is taxed to the seller as ordinary income, not as capital gain. Gain is determined by subtracting net premium cost from the sales price. When an annuity is sold after maturity, the cost basis of the contract must be reduced by the aggregate excludable portions of the annuity payments that have been received. The adjusted cost basis cannot be less than zero. The taxable gain cannot be greater than the sale price.

1035 Exchange of Non-Qualified Annuities & Transfers of Qualified Annuities

The tax-free exchanges of non-qualified annuities and tax-free transfers of qualified annuities may occur if the required paperwork is submitted to the insurance company. Agents must disclose a replacement transaction and follow all state and insurance company procedures for replacements. Insurance companies must notify the old insurance company promptly to allow them the opportunity to preserve the business, contact the annuity owner, and review the advantages and disadvantages of the proposed replacement. The following transactions are considered 1035 tax-free exchanges: 1. A life insurance or endowment policy to another life insurance or endowment policy 2. An annuity to another annuity 3. A life insurance or endowment policy to an annuity There are several requirements for valid 1035 exchanges: 1. Must have the same contract owner or owners on each side of the exchange 2. Must never exchange tax-qualified annuities for non-qualified annuities 3. Must keep qualified and non-qualified amounts separated 4. May transfer a tax-qualified annuity for another tax-qualified annuity 5. Never exchange an annuity to life insurance

Amounts Received as an Annuity

Amounts received as an annuity refers to a stream of regular, periodic payments (e.g., monthly, quarterly, semi-annually, or at least annually) and each payment is a combination of part return of principal and part earned interest or gain. A portion of the income payment is tax-free because it is a return of the original investment (cost basis in the contract). Once the investment in the contract has been fully recovered, all remaining annuity payments are fully taxable as ordinary income. Amounts received as an annuity are paid from deferred or immediate annuities that have been pensionized or annuitized. These annuity payments provide a certain amount each month for a fixed period, or for the life of the annuitant. Lifetime annuity payments represent protection against living too long and outliving one's retirement nest-egg. Most retirees are familiar with regular monthly income annuity payments from Social Security. Some retirees also receive a monthly pension check during retirement; these are annuity payments.

After the Required Beginning Date

In this case the account owner has already begun taking RMDs and the surviving spouse must continue taking distributions every year generally based on his or her life expectancy.

Defined Benefit Plans (Pensions)

Defined Benefit Plans, also known as pensions, were an important fringe benefit after World War II when employers were strictly limited by law concerning the pay raises they could provide employees. From 1945 - 1970, participation in private pension plans increased from approximately 19% of the workforce to about 45%. Key Question: What is "defined" in a defined benefit plan? The benefit is defined; the monthly amount the retiree will receive is calculated by the plan. The pension benefit is determined by a formula and typically paid in the form of a lifetime annuity. This is a use of the classic definition of an annuity, not normally applied to private pensions or a commercially available product. Payment calculations vary. If calculated on a dollar amount per month for each year of service, this is what it would look like: A pension plan rewards employees who work at the same company (or for the same union) for a prolonged period of time such as 20 - 30 years, for example. Employees who change jobs frequently are penalized by pensions since most plans have vesting schedules. If an employee does not work at the same employer long enough to be vested in the plan, changing jobs may result in the loss of retirement pension benefits.

Qualified Plans

Employee retirement plans qualify for certain tax advantages by being offered to all eligible employees, not just to a select few. Employers, by starting and funding a qualified retirement plan, receive current tax deductions for contributions made on behalf of the plan participants. Employees typically are not taxed on these qualified plan contributions at the time they are made by the employers. As additional deposits are made from each paycheck, these funds continue to grow and accumulate over time on a tax-deferred basis. Qualified plan account values continue tax-deferred growth while the employee is still working. At retirement, qualified plan distributions become taxable income to the retired workers. Rules for qualified plans are generally found in Section 401 of the Tax Code. While the plan has an administrator, typically the plan assets are held by a trust company or custodian bank. There are seven common types of qualified plans: Profit Sharing Plans (which includes both 401(k) and Roth 401(k) plans) Stock Bonus Plans Money Purchase Pension Plans Employee Stock Ownership Plans (ESOPs) Defined Benefit Plans Target Benefit Plans Plans for Self-Employed Individuals (Keogh Plans) Other Plans: Individual Retirement Accounts (IRAs) Roth IRAs 403(b) and 457 Plans Simplified Employee Pension Plan (SEP-IRAs) SIMPLE IRAs

Taxation Rules Based on Date Premiums Paid into a Non-Qualified Annuity

From time to time, Congress changes tax policy for various reasons. One of those tax law changes affected non-qualified annuities. Contributions to annuities before August 14, 1982, are taxed so that withdrawals come from principal first (tax-free), then interest gain (taxable) thereafter. This is known as "first in, first out" or FIFO. Contributions to annuities after August 14, 1982, are taxed "interest first". If the annuity cash value exceeds the amount invested in the contract, any distributions from that annuity are taxed as ordinary income to the policyowner, because the investment or interest gain comes out of any distribution first. This is known as "last in, first out" or LIFO. The gain is taxable when withdrawn. Any taxable annuity withdrawals before age 59 ½ are also subject to the 10% federal income tax penalty, unless an exception applies. If the annuity contract is paid out in regular periodic payments, then the basis is recovered pro rata over the life expectancy of the annuitant.

RMD Penalty

If RMDs are not taken, the penalty is 50% of the amount which should have been distributed under IRS regulations. Edna was required to withdraw a minimum $20,000 from her IRA this year based on her account value as of December 31 of the previous year and her age. Unfortunately she only withdrew $15,000 by the end of this year. She withdrew $5,000 less than what was required ($20,000 - $15,000), therefore, she incurred a penalty of $2,500 ($5,000 x 50%).

Exception to Tax Deferral: Annuities Held by Corporations or Non-Natural Persons

If a deferred annuity is not owned by a natural person (human being), but is owned instead by a corporation, association, or other non-natural person, the contract is not treated for tax purposes as an annuity contract and the income on the contract (annual interest or investment gain) is taxable each year as ordinary income. There are five situations where this exception does not apply. Any annuity contract that is: Acquired by the estate of a decedent upon death of the decedent. Held under a qualified pension, profit sharing, or stock bonus plan as 403(b) tax sheltered annuity, or under an individual retirement plan. Purchased by an employer on termination of a qualified pension, profit sharing plan, or stock bonus plan or tax sheltered annuity plan and held by the employer until all contract amounts are distributed to the employee or to his beneficiary. An immediate annuity where payments start no later than one year from the date of purchase, and income payments scheduled to be annually or more frequently, which provides for a schedule of substantially equal periodic payments. A qualified funding asset that is an annuity contract purchased from an insurance company for funding periodic payments for damages due to personal injury or sickness. An annuity contract held by a trust or other entity, as agent for a natural person, is considered held by a natural person. In this case, tax deferral applies.

Estate Taxation of a Non-Qualified Annuity

In general, a decedent's gross estate includes, among other assets, the value of annuities receivable by any beneficiary. (IRC § 2039)

Tax Deferral & Annuities

Non-qualified annuities have an established cost basis (usually the premiums paid, less any withdrawals) and will produce some tax-free income as the cost basis is distributed on a pro rata basis along with the investment gains. Once the basis has been fully paid out (and this may take 15-20 years), all subsequent payments are the investment gains from the annuity and are fully taxable. Some argue that mutual funds which hold tax-qualified accounts provide tax deferral at less cost than expense-laden variable deferred annuities with fees and charges built in. Variable annuities, however, have other important features and benefits other than tax deferral that may make variable annuities a compelling choice for some consumers. These other risk management and insurance benefits of variable annuities may include: Guaranteed lifetime income payments Family protection through the standard death benefit or the optional enhanced death benefit Living benefit provisions that may protect principal or provide a minimum guaranteed income Certain internal separate account management features such as dollar cost averaging or automatic asset rebalancing Indexed annuities may also provide some protection against down-side market risk that mutual funds do not offer. There are important calculation differences in taxable accounts, tax-free accounts, and tax-deferred accounts.

The Role of Tax-Qualified Annuities

Now we turn our attention to tax-qualified annuities, which make up more than half of the annual sales of annuities. Tax qualified annuities are purchased with either pre-tax dollars or are the result of a rollover from a qualified plan, such as a defined benefit pension plan or a defined contribution plan. Deferred annuities and mutual funds may be used as funding vehicles for 401(k), 403(b), 457 deferred compensation plans, SIMPLE IRAs, traditional IRAs, and Roth IRAs. Assets from any of these plans may be transferred to either deferred or immediate annuities and, if a trustee to trustee transfer, is a non-taxable event. Distributions from all tax-qualified retirement accounts, including qualified annuities, are always taxable whenever they occur. If distributions are taken prior to age 59½, a 10% excise tax is due, in addition to ordinary income tax.

Amounts Not Received as an Annuity — Partial Withdrawals

Partial withdrawals or amounts not received as an annuity, refer to a-once-in-awhile partial withdrawal that may include dividends, loans, withdrawals, and surrenders. If a non-qualified deferred annuity has a current value of $125,000, the contract owner may request a $12,000 partial withdrawal for any purpose. In this example, a partial withdrawal is not considered an "annuity" payment because it is not a regular, periodic payment consisting of principal and interest. Assuming that $100,000 was the original investment in the contract, then the $12,000 withdrawal would be taxable. If partial withdrawals continue at various and repeated intervals, eventually the cash value of a deferred annuity will be reduced substantially making it improbable for the owner to be able to live on reduced lifetime payments, if annuitized.

Taxation of Qualified Assets during the Lifetime of the Owner

Qualified annuities are taxed in the same way individual retirement accounts and qualified plans are taxed, at ordinary income tax rates. Capital gains tax rates do not apply. These accounts are tax deferred, not tax free; eventually the taxes will be paid. Since contributions to the retirement plan, IRA (including rollover IRAs), or tax-deferred annuity were originally made with pre-tax dollars, the basis is usually $0.00, meaning no basis exists. Consequently, all distributions are taxable whenever they occur and no matter who receives them (i.e., original account owner or a beneficiary after death of the account owner).

Nonguaranteed Distribution Options from IRAs

Required Minimum Distributions (RMDs) are required from all qualified plan assets when the account holder reaches age 72. This will force taxable distributions from all plans, especially IRAs, since they are most often used as the distribution channel. For many retirees, however, the minimum distributions may not be adequate to support their lifestyle. If so, RMDs may be combined with income from other nonqualified retirement savings to provide a greater retirement income from both sources. Guaranteed distribution options include income annuities from a defined benefit or a defined contribution plan. Retirees may use the rollover IRA strategy to move tax-qualified funds into a guaranteed lifetime payout annuity purchased from a life insurance company.

Distributions from an IRA or a Qualified Retirement Plan

Required distributions are the same, except that a surviving spouse beneficiary has the option of taking ownership of the IRA, with the distribution requirements being applied to the spousal beneficiary as the new owner. Upon the death of a qualified plan participant, the participant's plan balance is normally paid to a beneficiary. This final distribution, regardless of how it is taken, is generally subject to ordinary income tax. If the only designated beneficiary is the participant's spouse, and the participant died prior to age 72, distributions to the surviving spouse may be postponed until the close of the calendar year in which the participant would have turned 72.

Tax Deferral & Annuities

Tax deferred compounding is an important concept that must be discussed for any tax-qualified investment. One positive effect of earning money is more money is available; the down-side about earning more money is that taxes must be paid on the gains. Delaying or deferring the payment of income tax on investment earnings provides an opportunity to "earn interest on the interest." Tax-deferral is sometimes called triple compounding and can be very attractive: Interest is earned on the principal. Then, interest is earned on the interest. Finally, interest is earned on the money that would normally have been paid in taxes. In the long term, tax-deferred compounding allows the tax-deferred account or annuity to grow and accumulate faster than it would in an account that is taxed every year. Some annuity advocates contend that tax deferral is the primary advantage of annuities. It's important to remember that tax deferred is not the same as tax-free; eventually the taxes will have to be paid, but this is delayed until money is withdrawn from a tax-qualified account or a non-qualified annuity. All deferred annuities, whether they are tax qualified or non-qualified, enjoy tax deferral.

Taxation of Qualified & Non-Qualified Annuities

Tax qualified annuities are generally funded with pre-tax dollars. Non-qualified annuities are generally funded with after-tax dollars. Personally held financial assets include bank accounts, mutual funds, stocks, bonds, real estate, commodities, promissory notes, and insurance company backed cash accumulation vehicles—annuities. It's important to group these assets by categories so that tax-qualified accounts and non-qualified accounts are grouped together so that the consumer can better understand how taxes will impact each investment. The distinction between tax qualified and non-qualified annuities becomes important when lifetime income and death values are considered. Questions may include: How are annuities taxed during lifetime distribution? How are annuities taxed at the death of the annuity owner? Tax-qualified annuities are fully taxable at ordinary income rates when money is withdrawn. Non-qualified annuities have certain tax advantages when money is withdrawn. One of the advantages of non-qualified annuities is the original investment will be returned in equal tax-free installments over the payment period. These payments are not taxed since they are simply a return of principal; while the balance of monies received in annuity payments is the taxable gain or earnings. This is taxed at ordinary income tax rates, not capital gains rates (even if they come from a variable annuity stock separate account).

The Exclusion Ratio

The Exclusion Ratio, sometimes called the Exclusion Allowance Calculation, is a formula used to determine the percentage of annuity payment that is non-taxable as a return of the original cost basis. This calculation is different for fixed deferred annuities and variable deferred annuities. If the entire value of an annuity contract is used to create a stream of periodic payments, each of those payments will be partly included as taxable income and partly excluded from taxable income as a return of principal. Fixed Annuity Payments For fixed annuities, the excluded amount is determined by multiplying the payment by a fraction (the exclusion ratio) calculated by dividing the investment in the contract by the expected return under the annuity contract. The expected return is determined by IRS tables of life expectancies and interest rates, with an adjustment for any refund feature. Investment in the Contract ÷ Expected Return = Exclusion Ratio $50,000 ÷ $200,000 = 25% 25% of each income payment is not taxed since it is accounted for as a return of premium. After all of the cost is recovered then any and all remaining payments are considered income, and taxed accordingly. Variable Annuity Payments Variable annuities are not as predictable as fixed annuities. The investments in variable annuities are in the stock and bond market, through separate accounts. The separate account investment returns are highly volatile and unpredictable as evidenced by previous track records of gains and losses. Therefore, the exclusion ratio calculation is different for variable annuities. The excluded amount is determined by dividing the investment in the contract by the expected number of payments; the denominator is the life expectancy in years from the IRS annuity tables. Investment in the Contract ÷ Expected Return = Exclusion Amount Mary is 70 years old. She has paid a total of $100,000 in premiums into a variable annuity. Investment in the Contract = $100,000 Life Expectancy = 16 years $100,000 ÷ 16 years = $6,250 Exclusion Amount/Allowance If Mary's monthly annuity payment is $615, her annual annuity payment is $615 x 12 months = $7,380 This means that out of the $7,380 monthly payment, $6,250 is excluded from income, and $1,130 is taxable.