Planning for taxes is a critical element of any retirement plan, including all types of annuities. For most people, annuity taxes are fairly straightforward but knowing what to expect avoids surprises when you least want them.
Annuities have specific tax treatment and the difference depends on where the money comes from to fund the annuity and how the money is eventually distributed. Qualified assets are treated differently than non-qualified assets and income for each is treated differently as well.
Whether you are using an annuity for guaranteed income or safe accumulation there is a distinct difference between the two. With an income annuity, reportable taxes are mostly fixed while an accumulation annuity is taxed depending on the amount of growth in relation to the size of the withdrawal. Qualified IRA-type funds are pretty straightforward but non-qualified or after-tax money requires a little more calculation. None of it is very hard so this should be easy for everyone.
After Tax or Non Qualified Assets
Non-qualified assets come with a major benefit for any type of saver or retirement investor. Since you have already paid taxes on these assets, any other type of investment like bonds, CDs, mutual funds, or stocks will have you pay ordinary income taxes on any interest earnings or dividends. Growth inside an annuity is tax deferred until the money is withdrawn. Other investments create a 1099 each year but the annuity only does so if you’ve taken a withdrawal.
When a withdrawal is made, interest earned comes out first. It’s last-in first-out for anyone who knows accounting terminology. As an example with $100,000 let’s assume you made 5% so the account is now $105,000. If you take a free withdrawal of $10K, the $ 5,000 earnings are taxed at ordinary income and the $5000 of principal is a tax-free return of premium.
If you take it one year further, a 5% gain the following year would create an account value of $99,500 with an available free withdrawal of $9950. $4500 interest earnings are taxed as ordinary income and the remaining $5450 would be a tax-free return of premium. Now there’s $90K of basis left and we could continue the exercise as long as needed.
IRA or Other Qualified Assets
Taxation of annuities with qualified money is much more straightforward. Because a tax deduction was received for contributions and earnings are already tax-deferred, all distributions, whether free withdrawal or guaranteed income payments are fully taxable as ordinary income.
There are no additional tax benefits for deferral since that already exists within the IRA. This is not a disadvantage of the annuity because it exists as a rule for the IRA.
Taxation For Income Annuities:
For IRAs or qualified assets this is very simple, no matter what type of income annuity you have.
Non-qualified money can be taxed a couple different ways with an income annuity. The simple version of single premium immediate annuities typically have what’s called an exclusion ratio where a portion of each payment is return of principal and another portion is interest. The interest portion is taxable so you’ll get a 1099 for that amount each year. In some cases, an insurance company will state that all income payments are tax free until you recoup the initial investment. After that, each payment would be fully taxable. There’s a little wiggle room, depending on who your accountant is.
Fixed Indexed or Variable annuities with an income rider can be a little more complex. Since it’s last-in first-out for accounting purposes, any growth has to come out first so that part of every income payment will be taxable. Because growth is different every year then annuity taxes are going to be different as well. Any portion of the payment that is principal will be tax free but once the cash value drops to zero, all income payments would be fully taxable. This has been a deal breaker for more than one person who would get exactly what they expect from an immediate annuity.
Taxation for Inherited Annuities:
When it comes to passing an annuity to beneficiaries, there is an unlimited spousal transfer that doesn’t trigger a taxable event.
As for the next generation of beneficiaries, the rules on distributions above will apply. Qualified annuities give the second generation ten years to distribute the entire account and all distributions are fully taxed as ordinary income.
Non-qualified annuities are again last-in first-out but the beneficiaries have three different options for distribution.
A lump sum payout would create the biggest taxable event with all earnings fully taxable. Next is a five-year payout that would spread taxes evenly over the five-year distribution period. Finally is the lifetime stretch where the beneficiary would be able to take equal annual distributions over their life expectancy.
The stretch option results in the least amount of annuity taxes due but would be payable each year of the distribution. If there are multiple beneficiaries, each person could take a different option that works best for their individual circumstances.
Regardless of the option chosen, a distribution must be made within one year of the original contract owner’s death. I typically recommend that beneficiaries elect the stretch option because it can be changed to a shorter distribution period at any time.
Rather than commit to a major taxable event, this allows someone to take the time needed to factor in the benefits and disadvantages of either option.
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Episode 119: Annuity Taxes
Last Updated on January 6, 2024 by Bryan Anderson