Tax Treatment of Annuity Payouts
Deferred annuities are great for safely accumulating money to be used at some future date to enhance income. All
the money invested can grow tax deferred until it is removed. And with qualified annuities, the initial investment may
be deducted from gross income thereby also reducing current income tax.
However, when you begin to withdraw money from
an annuity, you must then pay taxes on all or a part of your distribution. Any money that has not been previously taxed,
including your initial investment, dividends and interest, will be taxed as ordinary income. Almost universally, that
tax will be higher than the long term capital gains tax.
The IRS treats qualified and non qualified annuities significantly
different, and understanding the differences can help you plan for taxes, distributions, exchanges and rollovers.
Taxes on Qualified Annuities
The IRS requires owners of a qualified annuity to begin taking mandatory distributions when they reach age 70 ½.
You reach age 70½ on the date that is 6 calendar months after the date of your 70th birthday. For example, if
your 70th birthday was on June 30, 2011, you reached age 70½ on December 30, 2011. If your 70th birthday was
on July 1, 2011, you reached age 70½ on January 1, 2012.
By the required beginning date, you must either:
- Receive the entire value of your
annuity account accruing after 1986, or
- Begin receiving periodic distributions in annual amounts calculated to distribute your entire account value accruing
after 1986 over your life or life expectancy or over the joint lives or joint life expectancies of you and a designated beneficiary
(or over a shorter period).
Minimum distribution tables are published by the IRS (publication #590) for determining the amount of income that you must
take each year after age 70 ½ based on the combined value of your tax qualified accounts. After the starting
year for periodic distributions, you must receive at least the minimum required distribution for each year by December 31
of that year. If no distribution is made in your starting year, the minimum required distributions for 2 years must
be made the following year (one by April 1 and one by December 31). All distributions from a qualified annuity must
be reported to the IRS as ordinary income each year.
You can change the beneficiaries on your annuity account at any
time, in some cases even posthumously, and the required minimum distribution amount can be changed to reflect the life expectancy
of your heir, again allowing more money to remain in the tax-deferred account.
Until it is annuitized, you can rollover
a qualified annuity to another qualified account (e.g., an IRA or another annuity) without creating a taxable event. This
might be done to increase the return on your policy or to change investment strategies. However, the same rules will
apply when it comes to taxes. So long as you are in a taxable bracket, income taxes will be due on any voluntary or
mandatory distributions from the new account.
Taxes on Non Qualified Annuities
A simple partial withdrawal is usually the most desirable method for obtaining income from an annuity, but even for a non
qualified annuity the entire withdrawal could be considered taxable income. For annuities purchased before Aug 14, 1982,
the FIFO (first-in, first-out) method is used for withdrawals. For annuities purchased after Aug 13, 1982, the withdrawal
rule is LIFO (last-in, first-out), meaning that earnings (the taxable part) will come out first.
Only if you set up
a systematic annuity income payment, will you get some tax relief by spreading out the taxable gain over the anticipated number
of years that annuity payments will be made. This does not reduce the amount that will ultimately be taxable, but it
does spread it out and make the burden more palatable.
Only the earned interest, and not the original investment, is
considered taxable in a non-qualified annuity. However, you have two options with the earned interest. You can
either withdraw it as needed or reinvest it, tax deferred, for a later date. If you choose to withdraw the interest,
you must wait until age 59 ½ even though this is not technically a retirement account. Otherwise, the IRS (not
the annuity company) will penalize you for an early distribution. However, you will never be forced by the government
to take your interest or principal out at any age.
Once your contract is annuitized, part of each payment (from a fixed
annuity) is considered a partial return of the basis (your contribution), and the other part (investment growth) is taxable
income using an exclusion ratio. Once you select your payout method with your insurance company, you should ask for
your exclusion ratio, which tells you how much is excluded from being taxed. If your exclusion ratio is 80% on a $1,000
monthly payout, then $800 is excluded from income tax and $200 is subject to ordinary income tax.
Step-Up Tax Basis
The big surprise with annuities occurs at the time of the total withdrawal of funds, which most often occurs upon the death
of the annuitant/owner. This is when the IRS considers all tax deferred parts, the original investment (if a qualified
annuity) and investment growth, as taxable income.
The “step-up in basis” rule in the tax code allows people
to pass most property that has grown in value to their heirs without ever paying taxes on the gains. It is quite common
today to see real estate and stocks, that have been owned for years and that have appreciated tenfold to a hundredfold, passed
on to heirs upon the death of the owner with no income tax whatsoever. If you had invested $25,000 in a standard mutual
fund and it grew to $100,000 and you died, your beneficiaries would receive $100,000 with NO tax (estate taxes not considered).
But a deferred annuity does not enjoy this tax feature. It is the only asset you can own that does not get a
“step-up in basis” at the time of your death. Specifically excluded from the step-up in basis rule, the
entire gain in the annuity is subject to income tax when received by the beneficiaries. This is in addition to the original
investment of a qualified annuity. If your beneficiaries had received a qualified annuity of $100,000, the entire amount
would be taxed as ordinary income. Assuming a 35% total federal and state tax rate, they would pay $35,000 in taxes
and net just $65,000. Quite a difference!
Credit Quality Concerns
A final factor to consider is the credit quality of the insurance company. Just because you have accumulated your annuity
at one insurance company over the past 20 years, you don't necessarily need to start your payouts with them. If another
insurer with a high rating has offered you a higher monthly payout, it might be worth your time to look into doing a tax-free
1035 exchange to the new insurer, but make sure to check the surrender charges on your current contract before you initiate
any transfer! Then have multiple quality insurance companies give you a quote on the current value of your annuity with
multiple payout options.
Deciding on the best type of annuity and best payout method is not an easy decision. Consider your priorities, the amount
of flexibility/control you desire, the income you need each month, and how long you think you will need these payments.
Stay healthy and place your bets on receiving significantly more money back than what you’ve invested.