Annuities and Tax Implications

Annuities are powerful financial tools, offering both income stability and tax advantages. However, navigating their tax implications requires a clear understanding of how contributions, withdrawals, and distributions are handled.

These considerations are crucial for maximizing the benefits of an annuity while staying compliant with tax regulations.

Qualified vs. Non-Qualified Contributions

Contributions to an annuity depend on whether it is qualified or non-qualified.

For qualified annuities, such as those part of an employer-sponsored plan or individual retirement arrangement, contributions are typically tax-deductible. In contrast, contributions to a non-qualified annuity are made with after-tax dollars and do not provide the same deduction benefits.

Regardless of the type, annuity payments consist of two parts: the return of principal, which is tax-free, and the earnings (such as interest, dividends, or capital gains), which are taxed as ordinary income.

Determining How Much Of Each Annuity Payment Is Taxable

To determine the taxable portion of each annuity payment, the exclusion ratio is applied. This simple formula divides the total investment in the annuity by the expected return to calculate the percentage of each payment that is tax-free. For example, if an individual invests $100,000 in an annuity and expects a total return of $150,000 over 20 years, the exclusion ratio would be 67%.

In this scenario, if annual payments are $7,500, approximately $5,025 of each payment would be tax-free, while the remaining $2,475 would be taxable as ordinary income. This ratio ensures a fair and proportionate allocation of taxable and non-taxable income over the life of the annuity.

Withdrawals and Early Distributions

Withdrawals from annuities are subject to specific tax rules, especially during the accumulation phase. Generally, deferred annuities follow a last-in, first-out (LIFO) approach, meaning earnings are withdrawn and taxed before the principal.

However, annuities purchased before August 14, 1982, are treated under a first-in, first-out (FIFO) rule, where principal withdrawals occur first.

Premature withdrawals, defined as those taken before age 59½, incur a 10% penalty tax on top of ordinary income tax, unless specific exceptions apply, such as the owner’s disability, death, or the purchase of an immediate annuity. Partial withdrawals and cash surrenders are similarly taxed, with earnings taxed first before principal amounts.

Distributions Upon Passing Away

When an annuity owner passes away during the accumulation phase, the beneficiary typically receives the greater of the accumulated value or the total contributions made to the annuity. Any amount exceeding the premiums is considered taxable income.

To mitigate the tax burden, beneficiaries may opt for a life income or installment option, provided the selection is made within 60 days of the annuitant’s death. This flexibility allows beneficiaries to spread out payments and manage the tax implications more effectively.

Section 1035 Contract Exchanges

An important feature of annuities is the ability to transfer contracts without immediate tax consequences under Section 1035 of the Internal Revenue Code. This provision allows annuity owners to exchange one annuity contract for another or convert a life insurance policy into an annuity without recognizing a taxable gain.

The process defers the tax liability until distributions are made, enabling policyholders to adjust their financial strategies without incurring immediate penalties.

Corporate-Owned Annuities

Corporate-owned annuities present unique tax considerations. If a corporation owns an annuity and names itself or another non-natural entity as the annuitant, the interest earned is taxable in the year it is credited as ordinary income.

However, if the corporation names a natural person, such as an employee, as the annuitant, the interest may be tax-deferred. Exceptions to this rule include situations where an annuity is held by a trust or non-natural entity as an agent for a natural person or when the annuity is part of a qualified retirement plan.