Taxation of Annuities
Taxation of Corporate-Owned (Nonqualified) Annuities
Annuities owned by non-natural entities (e.g., corporations) are taxed differently than annuities owned by natural persons. When owned by non-natural entities, the accumulating values in a nonqualified deferred annuity contract are annually subject to current taxation. Current tax is payable on the annual increase in the contract's value. If the non-natural entity is a trust that operates for the benefit of a natural person, this rule does not apply. In other words, the trust is treated as a natural person and is not subject to current taxation.
Payout (Annuitization) Stage
When a deferred annuity is annuitized (or an immediate annuity is bought), the periodic payments it generates for the annuitant or the beneficiary consist partly of principal and partly of interest earnings. Here, too, the interest portion is taxed and the principal is not. Determining the split between taxable interest and nontaxable principal in an annuity payment is achieved through the exclusion ratio.
Annuity Withdrawals Before Age 59½
To encourage the use of annuities for long-term retirement savings and discourage early withdrawals, a 10 percent penalty tax is imposed on withdrawals before age 59½. If the annuity contract owner withdraws money from the annuity before age 59½, then the taxable portion of the withdrawal is charged a 10 percent tax penalty in addition to the ordinary income tax paid on the earnings distribution. This same tax penalty applies to pre-59½ distributions from qualified retirement accounts and modified endowment contracts. -Penalty Tax Exemptions There are three situations in which a withdrawal from an annuity before age 59½ will not be penalized with the 10 percent tax: 1. The contract owner dies. 2. The contract owner becomes disabled. 3. The withdrawal is taken in substantially equal payments over the owner's life
Quiz
Question 1 What is the only part of an annuity's death proceeds that is taxable? the amount that exceeds the amount the annuitant has received as income under the contract the amount that exceeds the annuitized amount -the amount that exceeds the annuitant's cost basis the amount that exceeds the amount the owner paid into the contract The only part of the proceeds that is taxable is that which exceeds the amount the owner paid into the contract, not that which exceeds the amount the annuitant has received as income under the contract. Question 2 Interest that accumulates on funds paid into deferred annuities is taxed in which of the following ways? It is taxed as it enters the annuity. -The funds are not taxed while they remain in the annuity. It is taxed before entering the annuity. It is taxed during the conservation stage. The interest that accumulates on funds paid into annuities is not taxed while the funds remain in the annuity. This is one of the main benefits annuities offer. Question 3 Annuity contracts include a provision to pay a death benefit if the owner or annuitant dies before the contract annuitizes. What does this death benefit typically equal? -either the contract's accumulated value or the amount of premium the owner invested, whichever is greater either the contract's accumulated value or the amount of premium the owner invested, whichever is less the contract annuity amount or the owner's imputed value amount, whichever is greater either the contract's accumulated value or the amount of any outstanding loans, whichever is greater The death benefit typically equals either the contract's accumulated value or the amount of premium the owner invested, whichever is greater. Question 4 When owned by non-natural entities like a corporation, the accumulating values in a deferred annuity contract are taxed in which one of the following ways? Income tax is payable on the full contract value. Capital gains tax is payable on the annual increase in the contract's value. Taxation is no different with annuities owned by non-natural entities than it is with those owned by natural persons. -Income tax is payable on the annual increase in the contract's value. Annuities owned by non-natural entities (e.g., corporations) are taxed differently than annuities owned by natural persons. Question 1 At age 49, Caleb took a $15,000 distribution from his deferred annuity. In addition to paying income tax on the $15,000 withdrawal, what else will Caleb probably have to pay? a penalty tax of $7,500 -a penalty tax of $1,500 no penalty a penalty tax of $1,000 In addition to paying income tax on the $15,000 withdrawal, Caleb also pays a 10 percent penalty, or $1,500. Question 2 If Sam, who owns a deferred annuity, withdraws funds as a full or partial surrender before the contract annuitizes, what happens? -Withdrawals are taxable until accrued earnings have been fully withdrawn, at which point remaining withdrawals (of principal) are not taxable. Fifty percent of Sam's withdrawals are taxable income. Sam's annuity withdrawals are tax free. Up to $40,000 of Sam's withdrawals are tax free. If Sam withdraws funds as full or partial surrenders before the contract annuitizes, any withdrawn annuity interest earnings are taxable. Question 3 The IRS has identified three situations in which pre-59 ½ annuity withdrawals are not penalized. The IRS does not impose the 10 percent penalty if the withdrawal is made for any of the following reasons, EXCEPT: The contract owner dies. -The owner can establish financial hardship. The withdrawal is taken in substantially equal payments over the owner's life. The contract owner becomes disabled. Financial hardship does not create an exception to the 10 percent penalty. Question 4 If Harry, age 58, withdraws funds from his annuity, the taxable portion of the withdrawal may also be assessed which of the following? 50 percent penalty nothing 15 percent surcharge -10 percent penalty If a person withdraws funds from an annuity before age 59 1/2, the taxable portion of the withdrawal is charged a 10 percent penalty.
Annuity Death Benefits
Annuity contracts include a provision to pay a death benefit if the owner dies before the contract annuitizes. This death benefit typically equals the greater of the contract's accumulated value or the amount of premium the owner invested. Unlike life insurance death benefits, the death proceeds from an annuity are taxable to the beneficiary. Here, too, only the interest is taxable; the principal is received tax free. The beneficiary must generally choose one of the following options under which to receive the death benefit: -an immediate lump-sum payment -withdrawals over a period no longer than five years Taxation of Qualified Annuities A qualified annuity is an annuity that is used in a tax-qualified retirement plan, such as an individual retirement account (IRA), a tax-sheltered annuity (TSA, or Internal Revenue Service 403(b) plan), or some other plan that receives favorable tax treatment. An employer may use a qualified annuity to fund a retirement plan for the benefit of its employees. Money that is tax deductible going into an asset is usually taxable coming out. Contributions into a qualified retirement plan are generally tax deductible. On the other hand, 100 percent of all payments are taxable. That is, the principal is taxable as well as the interest portion of every payment. This is true with annuities used in a qualified plan as well as any other type of asset.
Distributions During Accumulation Stage
Deferred annuity withdrawals are treated on a "last-in, first-out" (LIFO) basis, which means withdrawals are treated first as a taxable distribution of interest. Earnings are taxed as ordinary income. Only after all interest earnings have been withdrawn are subsequent withdrawals treated as a distribution of nontaxable premiums. Annuity principal (i.e., premiums paid into the contract) is not taxable when distributed. This is because premium payments for nonqualified annuities are not tax-deductible. Since the premiums were funded with after-tax (not tax-deductible) dollars, they are not taxed when withdrawn. For example, assume Clyde bought a single-premium deferred annuity ten years ago. He paid $25,000. Today, the contract's value is $46,000. The contract owner's cost basis is $25,000; the interest earnings are $21,000. If Clyde were to withdraw $15,000, it would be fully subject to tax since it would be deemed to come entirely from interest earnings. This reduces the interest earnings portion that remains in Clyde's contract to $6,000. If Clyde were to withdraw another $15,000, only $6,000 of that second withdrawal would be taxable. The remaining $9,000 is considered a return of nontaxable premiums. Annuity interest earnings are taxed at ordinary income tax rates, not capital gains rates.
Key Points
-Deferred annuity withdrawals are treated on a "last-in, first-out" (LIFO) basis, which means withdrawals are treated first as a taxable distribution of interest. -Annuity principal (i.e., premiums paid into the contract) is not taxable when distributed. -The exclusion ratio identifies the portion of an annuity payment that is excluded from tax. The balance of the payment (the portion attributed to interest earnings) is taxable. -The exclusion ratio applies until all principal in the contract has been recovered by the annuitant tax free. After that, annuity payments are fully taxable. -Money that is tax deductible going into an asset is usually taxable coming out. Contributions into a qualified retirement plan are generally tax deductible. On the other hand, 100 percent of all payments are taxable. -When owned by non-natural entities, the accumulating values in a nonqualified deferred annuity contract are annually subject to current taxation.
The Exclusion Ratio
The exclusion ratio identifies the portion of an annuity payment that is excluded from tax. The balance of the payment (the portion attributed to interest earnings) is taxable. The exclusion ratio is expressed as a formula: (investment in the contract/expected return) = amount excluded from income The investment in the contract is the sum of premiums paid into it. The expected return is the annual income received after annuitization multiplied by the annuitant's remaining life expectancy.
Example of the Annuity Exclusion Ratio
At the age of 40, Lydia bought a fixed deferred annuity with a first premium payment of $20,000. Over the years, she made more payments for a total of $50,000. Today, at age 65, Lydia's contract is worth $142,000: -$50,000 in total invested premiums -$92,000 in interest earnings Lydia decides to annuitize the contract under a straight life income option. This would produce $833.30 a month, or $10,000 a year in income. According to IRS life expectancy tables, Lydia is expected to live 20 more years. Therefore, under her straight life annuitized payout option, Lydia's expected return is $200,000 ($10,000/year × 20 years). Lydia's exclusion ratio is calculated as follows: ($50,000 (investment in the contract)/ $200,000 (expected return) = 25 percent (amount excluded from income) Thus, Lydia can exclude from income tax 25 percent of her annual $10,000 annuity income ($2,500). The remaining $7,500 is the income portion attributed to the contract's interest earnings and is taxable as ordinary income. The exclusion ratio applies until all principal in the contract has been recovered by the annuitant tax free. After that, annuity payments are fully taxable. If Lydia lives beyond her 20-year life expectancy, the insurance company will still continue to make annual payments of $10,000. But, at that point, they will be fully taxed. The annuitant can select a payout option that provides for continued annuity payments to a beneficiary after the annuitant's death. In this case, the beneficiary will continue to exclude from his or her income the same portion of each payment as originally computed for the annuitant.
Accumulation Stage: Tax-Deferred Accumulation
Interest that accumulates in a deferred annuity is not taxed while the funds remain in the annuity. In other words, the accumulation is tax-deferred. As long as it remains in the annuity, earnings are not taxable. This is one of the main tax benefits offered by annuities If money is withdrawn from a deferred annuity during the accumulation stage (that is, before annuitization), there are income tax consequences.
