Fixed Indexed Annuity Taxes
Planning for taxes is a critical element of any retirement plan, including fixed indexed annuities.
Planning for taxes is a critical element of any retirement plan, including fixed indexed annuities. For most people, it’s 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. Qualified assets are treated differently than non-qualified assets and income for each is treated differently as well.
Non-Qualified: After-tax cash or brokerage
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Growth inside a fixed indexed annuity is tax deferred until the money is withdrawn.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.
As shown in the table below, 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.
Situations like this happen when guaranteed income riders are involved because of the last-in first-out rule. Since guaranteed income is mostly level payments and interest has to be taken first, the growth in the underlying account can create variable tax reporting.
Fixed indexed annuities may never lose money but they don’t always grow. We can take the illustration out three years to see how tax reporting can change from year to year.
It is hard to plan taxes on a fixed indexed annuity when guaranteed lifetime income is taken. Each payment is a portion of principal and interest but the interest isn’t the same every year. Eventually, the account value goes to zero and then the full income payment would be taxed as ordinary income.
Qualified Assets: IRA, Roth, 401(k) etc…
Taxation of fixed indexed 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 they already exist within the IRA. This is not a disadvantage of the annuity because it exists as a rule for the IRA.
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. This results in the least amount of 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 each distribution option.
Newsletter May 29, 2021: Annuities for Inheritance
The taxes for fixed indexed annuities are fairly simple but there are so many different situations that each needs to be explained individually. Qualified annuities are pretty much the same no matter what you do but non-qualified annuities have several different ways it could be taxed, depending on how it’s used and who is paying taxes.
It is critically important that this is well understood before you purchase a fixed indexed annuity. Novices in the business may leave you with an unpleasant surprise but capable professionals will put your mind at ease so you know exactly what to expect.