Annuity Taxes

The following list provides links to some of the key terms discussed in this chapter on annuity taxes:

• Qualified
• Non Qualified
• Tax Deferral
• Exclusion Ratio
• Early Distribution
• Required Minimum Distribution
• Surrenders
• Gifts and Assignments
• Death of Owner
• Section 1035 Exchange

As explained in the chapter on annuity products, all annuities share three common features:

1) Money goes into the annuity—from you (the consumer) to the insurance company.

2) That money stays with the insurance company for some period of time and does something while it is there.

3) The money comes back from the insurance company to you. 

It is helpful to use this three step process when discussing annuity taxation.  The first step is probably the simplest of the three since there are basically two options:

• Qualified: funds coming into the annuity are from a qualified plan such as a 401k, 403b or conventional (non-Roth) IRA.  In this case, the contributions are made with pre-tax dollars and taxable income is reduced by the amount of the qualified contributions.
• Non Qualified: funds coming into the annuity are made with after-tax dollars and there is no reduction in taxable income.

Tax Deferral

The second step—what happens to the money while it is with the insurance company—is also relatively simple: annuities are tax advantaged products, and this advantage involves tax deferral.  Similar to a 401k or conventional IRA, funds in an annuity grow and compound tax free.  Any interest, dividends or capital gains incurred are free of taxes.  This tax benefit can have a profound impact over the course of many years.

The third step—how the money is distributed and comes back to you—is where things get more complicated. 

With all annuities—whether qualified or non-qualified—income distribution that is not considered return of principal is taxed as ordinary income.  The portion of the distribution that is considered return of principal is not taxed.

The amount of non-taxable return of principal is determined through a calculation referred to as the exclusion ratio.  The exclusion ratio is determined by dividing the total amount of money that went into the annuity by the total amount that is expected to come out of the annuity. 

For example, assume that John—at age 65—purchased a single premium immediate annuity with $20,000.  Assume that this annuity pays $135 per month or $1,620 per year.  Also assume that John is expected to live another 18 years.  As a result, John’s expected income from the annuity totals $29,160.

In this example, the exclusion ratio is 68.5 percent ($20,000 / $29,160).  Apply this exclusion ratio to the annuity payment to determine the amount that is not taxed (.685 x $1,620 = $1,109.70) and the amount that is taxable ($1,620 - $1,109.70 = $510.30).

Determining the exclusion ratio for a variable annuity is a bit different since the payout amount is variable or unknown.  It is assumed that the payout is equal to the amount that went into the variable annuity.

It is important to note that the exclusion ratio is not applied to distributions from qualified annuities.  The entire amount of the payout from a qualified annuity is taxed as ordinary income.  It is also important to note that the exclusion ratio continues to apply to annuity payments (even those in excess of the amount that went into the annuity) that began before January 1, 1987.

Similar to an IRA, early distributions made from an annuity before age 59 ½ are subject to a 10 percent penalty on the amount of taxable funds withdrawn.  This 10 percent penalty is in addition to ordinary income taxes.   However, unlike an IRA, distributions from a non-qualified annuity are not subject to the required minimum distribution mandate at age 70.5.  When withdrawals are made before an annuity’s maturity date, the taxable portion of the distribution is considered to take place before any return of principal.

When a deferred annuity is surrendered, the difference between the cost basis and the amount received is taxable.  Gifts and assignments of annuities (other than to a spouse) are treated in a similar manner—the difference between value at time of transfer and cost basis is taxable as ordinary income for the annuity owner.

When an annuity owner dies, the tax implications are—to say the least—complicated, and a detailed analysis is beyond the scope of this buying guide.  Tax advisors and financial advisors should be involved in the analysis.

 At the highest level, though, the value of the annuity does not cease to exist when the owner dies.  There may be additional annuity payments to distribute to beneficiaries, and any increase in contract value will have tax implications.

In addition, you should know that the law will require some sort of distribution will have to occur when an annuity owner dies.  When this distribution must take place and in what form it must (a single payment or series of payments) depend on whether or not the annuity has begun its payout or distribution phase.

The tax-deferred status of annuities allows them to be exchanged for like-kind (similar) contracts on a tax-free basis.  This exchange occurs through what is referred to as a section 1035 exchange.  Section 1035 refers to the relevant section of the Internal Revenue Code.

A section 1035 exchange allows:

• The exchange of one annuity contract for another annuity contract.
• The exchange of a life insurance contract for an annuity.
• The exchange of one life insurance contract for another life insurance contract.

A section 1035 exchange can be useful if a product is not longer needed.  The tax-free exchange is also useful if there is a change in personal circumstances or economic conditions.  Last, a section 1035 exchange allows annuity owners to upgrade to new and improved products. You should be aware that while exchanges can occur tax-free, any remaining surrender charges will apply.