Annuities provide steady reliable income.
One of the great things about annuities is their ability to provide you with income for the rest of your days — in effect, a lifetime stream of income that you can never outlive. Even if you live to be 110, you're still guaranteed to be paid by the insurance company if you chose to receive annuity payments for life (other payout options are available as well, known as "period certains."). What’s not so great about annuities is that you may not live long enough to even get your original investment back, and that many annuities provide poor returns.
In the Investment section of this website, the three major types of annuities were described: Fixed, Variable and Indexed. Regardless of the type of annuity you own, it will fall into one of two IRS categories: qualified (i.e., annuities purchased with pre-tax dollars) or non qualified. (An annuity cannot be both qualified and non qualified; it is one or the other.)
The Investment section of this website also defined the two phases (accumulation and payout). In this section we’ll deal with the payout phase.
Once you reach age 59 ½ you can begin to withdraw funds from an annuity without incurring a 10% penalty charge. This minimum age requirement is true whether your annuity is qualified or non qualified. When you reach age 70 ½ you must begin taking mandatory minimum distributions from qualified annuities, whereas non qualified annuities have no such requirement. This will be further explained later in the Tax Treatment part of this section.
The payout process works the same for all types of annuities. A monthly income is provided to you for as long as you choose, regardless of whether you have a lump-sum (immediate) annuity or have been contributing into the annuity for years.
Annuity Payment Options
There are a few different methods for taking annuity payouts. Generally speaking, the two most common methods to receive cash payouts are the annuitization method and the systematic withdrawal schedule. The other is lump-sum payment. Following is a definition of these options, how they are calculated and how they are taxed.
The annuitization method gives you some guarantee of monthly income for a determined period. However, keep in mind that:
- All of these options lock you in to a specific payout program that cannot be changed, and
- Unless you’ve purchased inflation protection, the periodic (monthly) payments are fixed and therefore have reduced purchasing power each year due to inflation.
Despite the cost (i.e., reduced payouts) of inflation protection, it’s generally worth getting because the steady drip of even low inflation can eat into your buying power over time. You can buy an annuity that will boost your monthly income each year based on a prescribed inflation rate (typically 3% or 4%), but a better option is to get one based on the actual change in the Consumer Price Index.
Here are the most commonly available annuitization options:
- Life Option
The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant. This option provides an income stream for life, which is an effective hedge against outliving your retirement income.
- Joint-Lives (or Joint & Survivor) Option
This common option allows you to continue the retirement income to your spouse upon your death. The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife. The amount paid to the second annuitant may or may not differ from the amount paid to the first annuitant.
- Period Certain
With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years. Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years.
- Life with Guaranteed Term
This option combines the income for life provision of the life option with a guaranteed return of a portion of your investment. It pays you for as long as you live, but adds a guaranteed period (e.g. 10 years). If you die before the guaranteed period is over, your annuity is obligated to continue to make payments to your estate or beneficiaries for the period specified.
Systematic Withdrawal Schedule
Under this method, you can select the amount of payment that you wish to receive each month and how many you want to receive. Your payments may vary in amount for a specified length of time or for life. However, the insurance company that sold you the annuity will not guarantee that you will not outlive your income payments. How much you receive and how many months you receive payments depends on how much you have in the account. With this option, you assume the life-expectancy risk.
Systematic withdrawal schedules are common with variable and indexed annuities that have not been annuitized. With these annuities the amounts you receive may depend upon earnings from mutual funds and your guaranteed interest rate.
Taking out the assets in your annuity in one lump sum is usually not recommended because, in the year you take the lump sum, ordinary income taxes will be due on the entire pre-tax contributions and the investment-gain portion of your annuity. Clearly, this is a very inefficient payout option from a tax minimization perspective.
Electing Not to Take Payments
If you have no need for income from the funds that have accumulated in your annuity, you can leave the funds there and have the annuity transferred to your beneficiary at your death. However, keep in mind that with qualified annuities you must begin taking mandatory minimum distributions at age 70 ½, and there is the Step-Up tax basis consideration (see below).
Factors that Determine Your Monthly Payment
There are several factors that insurance companies use to compute your monthly payment amount. Two of the most common are gender and age – both of which affect your life expectancy. Since women have longer life expectancies than men, women won't receive as high of a payment as their male counterparts. And, of course, the older you are, the lower your life expectancy. A 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man because the older man's life expectancy is shorter.
Another major factor that affects the size of your monthly payout is the payout option that you select, which affects how long the payments will last. For example, if you select the joint-lives option, your monthly payout most likely will be lower as the payment continues to your spouse after your death.
Finally, the size of your monthly payout depends also on the insurance company that you use, and its expected investment returns on your money. If the company can make a 5% instead of a 3% return with your money, your payment will be higher. However, the increase in your payment when returns are higher depends on whether you select a fixed monthly payout or a variable monthly payout from your annuity. If you select the fixed amount, your payout will not change, and the insurance company assumes all investment risk. Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so you assume the market risk.
Tax Treatment of Annuity Payments
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, 2020, you reached age 70½ on December 30, 2020. If your 70th birthday was on July 1, 2020, you reached age 70½ on January 1, 2021.
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.