Annuities, as I have mentioned before, are a hot topic in the financial planning community right now. I can find plenty of financial advisors that love annuities, but I can also find plenty of others that hate annuities.
Love annuities or hate them, I believe that most financial advisors will agree they can be complex. And depending on which type of annuity is being discussed, they can be very complex.
Furthermore, it’s not simply the annuity itself that may be complex; it’s also the differing tax rules associated with that annuity.
Depending on whether an annuity is in an accumulation or distribution phase and whether the investment is IRA or non-IRA money, the tax ramifications may be very different.
So if you find yourself considering purchasing an annuity or if you already own an annuity, it makes sense to know the tax opportunities and pitfalls of owning an annuity as well as understanding the annuity itself.
Accumulation and Distribution Stage
Annuities grow tax deferred. This means you will not pay tax on money invested in an annuity until the money is distributed.
This rule is the same for an IRA annuity and a non-IRA annuity. This rule is also the same regardless of the type of annuity owned: fixed, variable, indexed, or deferred. Any money invested in the annuity will accumulate tax deferred.
Here is what you should know regarding tax deferral in an annuity:
If your money is in an IRA (outside of an annuity), you have tax deferral. All IRAs grow tax deferred. This means you don’t need the annuity in order for your money to continue to grow tax deferred.
If you contribute non-IRA dollars to an annuity, any future growth will be taxed deferred. This means any and all growth will not be taxed until it is actually distributed from the annuity.
During the accumulation phase of an annuity, the rules regarding taxes are simple. The money accumulates tax deferred. However, it is during the distribution phase that things become increasingly difficult.
Distributions from an annuity will often be the result of one of two actions:
- A withdrawal
This distinction is important because it may impact how taxes are figured on your distributions.
Annuitize versus Withdrawal
When distributing assets from an annuity, you will likely have two choices: annuitize or withdrawal.
When you annuitize an annuity, you are giving up rights to the value of the contract in exchange for an income stream. Often the income stream is tied to the life of one or more persons, such as you and your spouse. The amount of income you receive is directly related to the value you are exchanging, your age(s), your gender, and for how long you plan to receive the income from the annuity (among other things).
The key fact that you need to remember about annuitization is that you give up the rights to a lump sum of money.
A withdrawal, on the other hand, operates like a withdrawal from any other account you have (think your bank account). A withdrawal, taking money out, simply lowers the remaining account balance.
Distribution Stage – IRA
Eventually, it is likely (and even necessary for required minimum distributions) that you will need to take money from your IRA annuity. When you do, all distributions from the annuity will be taxed as ordinary income. (This assumes there are no after-tax dollars in the IRA, which is rare but sometimes occurs.)
From a practical standpoint, distributions from an annuity IRA and a non-annuity IRA are identical. Distributions are taxed as ordinary income.
Additionally, for IRA annuity distributions, it doesn’t matter whether the money is withdrawn via an annuitization or via a withdrawal. The distributions are taxed the same.
Distribution Stage – Non-IRA
Distributions from a non-IRA annuity are more complex than their IRA annuity counterparts. Any deferred gain in the annuity is subjected to ordinary income tax upon distribution from the annuity.
How much of this gain is taxed and when this gain is reported are subject to rules pertaining to whether the distribution is due to a withdrawal or due to annuitization.
Distribution as a Withdrawal
Assuming a withdrawal, all gain in the annuity is distributed first and taxable in the year of distribution. (You take the tax deferred gain first.) Once the gain has been received, the remaining distributions will be a return of premium and will be non-taxable.
Let’s look at a hypothetical example:
- Initial Premium and Basis: $75,000
- Current Value: $100,000
- Tax Deferred Gain: $25,000
Assuming the client takes a distribution of $10,000, the entire amount will be subject to ordinary income taxes, as gain comes out first.
If we assume a distribution of the entire account balance, $25,000 will be taxed as ordinary income, and $75,000 will be a tax-free return of premium.
Distribution When Annuitized
If the contract is annuitized, the annuity payments will be subject to an exclusion ratio. An exclusion ratio means that a portion of each payment received will be gain and another portion of each payment will be return of premium.
The impact of an exclusion ratio is that a portion will be tax free and a portion will be taxable.
For example, let’s assume a 67-year-old male purchases an immediate annuity for $100,000 using all non-IRA dollars. The payment and taxes are as follows:
- Monthly Income: $557/month ($6,684/year)
- Taxable amount: $105
- Non-taxable return of premium: $452
This taxable amount is due to the imbedded earnings built into a single premium immediate annuity.
When considering an annuity, or evaluating the one you currently have, it’s important to evaluate the annuity itself as well as the tax implications.
With good planning and a thorough understanding of your options, you can incorporate your annuities into a strategic retirement income strategy that attempts to withdraw your assets in the most efficient way possible.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.