5 Takeaways on Annuities & Taxes
By Sam Deleo
Tucker Advisors Senior Content Specialist/Editor
First, let’s get this out of the way: Annuities are not all the same, nor are they for everyone. But if you are planning for your retirement, annuities can very effectively provide stable, long-term income.
The value that annuities can offer to retirees also extends to tax mitigation. You can use annuities as safe, tax-free havens for your savings as you build toward retirement. But it’s important to note that this tax-free status ends when you begin withdrawing from annuities. And the rates you pay then will scale as ordinary income, not a special lower rate, as with capital gains.
A qualified annuity means you have purchased the product with pre-tax dollars, while you would fund a non-qualified annuity with money that has already been taxed. Investors often fund qualified annuities from 401(k) plans, IRAs or other tax-deferred accounts. People can enjoy tax-free funding of a non-qualified annuity by using a Roth 401(k) or Roth IRA if specific guidelines are met.
Whether you purchase a qualified annuity or non-qualified annuity, the interest earnings will face the prevailing income tax rates at the time of the disbursements. Solely for the purposes of illustration, if you invested $100,000 and received $10,000 for 10 years, any money you receive above this amount will face income tax rates, regardless of whether it is a qualified or non-qualified annuity. This difference between your principal and this interest portion of the taxed annuity is often referred to as the “exclusion ratio.”1
The insurance issuer of the annuity will determine the exclusion ratio based on your life expectancy, so your monthly payments from a non-qualified annuity, for instance, would have a portion that is non-taxable and the interest portion, usually much smaller, that is subject to income tax rates. Additionally, if you live past your life expectancy, then 100 percent of your disbursements—which, remember, would now be more than the principal you paid for the annuity—are taxed as ordinary income.
Here are five other important tax considerations regarding annuities.
1. What if you withdraw from an annuity early?
You will most likely have to pay a 10-percent early withdrawal tax on any sum you withdraw from your annuity prior to age 59½. Some exceptions include:
– The owner dies
– The owner is disabled [within the guidelines of IRC 72 (m)(7)]2
– The gain on Pre-TEFRA contributions (prior to August 14, 1982)3
– It is a non-qualified immediate annuity, which begins its payout within a year of purchase
– 72(q) and 72(t) payments, where life-expectancy payments continue for five years or to age 59 ½, whichever take longer4
For the full list of exemptions to the early withdrawal tax, visit the IRS website section covering retirement plans and taxes on early distributions.
2. Can you transfer ownership of a non-qualified annuity?
You can transfer ownership by creating or subtracting joint owners, transferring the policy to a new owner, or reassigning the policy. When these ownership changes occur, the interest earnings at the time of the transfer are taxable to the original owner, and the 10-percent early withdrawal tax can apply if the original owner is not yet 59½. Exceptions include:
– Ownership is transferred from one spouse to another, or a spouse is deleted or added
– A divorce triggers the transfer of ownership
– The transfer is between the owner and his/her revocable (grantor) trust
Of course, it’s wise to think carefully about your grantor designations at the time of purchase.
3. What are the consequences of the LIFO policy (“last in, first out”) on taxing a non-qualified annuity?
The way the chronology of taxes occurs on a non-qualified annuity is as follows: First, your interest earnings are taxed; Secondly, your principal is taxed if it is a qualified annuity, but is received untaxed if it is a non-qualified annuity; and lastly, the insurer’s disbursements you receive are then taxed.
“This is the coveted feature of annuities,” says Tim Kilzer, business developer at Tucker Advisors, “to be able to still get paid with the insurer’s money after you have burned through all the principal investment you made on the policy in the first place, and then all the interest that money made. At this point, you are free and clear, you’re receiving the insurance company’s money. But that revenue has never been taxed, so you’ll still have to pay income tax on that money.”
4. What is the tax benefit of an immediate annuity, like a SPIA (single premium immediate annuity)?
Purchasing an immediate annuity gives you access to withdrawals in a much shorter time frame and, generally speaking, with a higher monthly income than a comparable fixed indexed annuity.
The insurance company applies a uniform tax across all of the payments in an immediate annuity, and that tax rate never changes. These annuities are great tools for people who want to retire immediately and may not have time to wait on a fixed income annuity, because they will know exactly what their income and tax rate will be going forward till the day they die.
5. Choosing the right taxable annuity depends on your individual circumstances?
The purpose of money dictates where you put it, and this applies to annuities, too.
“If I just want to grow money,” says Kilzer, “I can put it in a growth annuity with no income rider and the highest available rates and caps. It will be taxed by the LIFO sequence on a non-qualified annuity, or taxed as ordinary income on a qualified annuity. The fixed indexed annuity works great if I need deferred income but want guaranteed income for the rest of my life. And, if I need immediate income at the highest possible amount from that asset, and I don’t care about having access again to the principal, then a SPIA is the choice. I’ve seen plenty of people who have bought all three to serve different financial needs at different times in their lives.”
The way taxes affect annuities is a complex topic. There are many features and exceptions that that we did not cover here. Consequently, you should always review annuities with a certified financial planner or tax accountant during your assessment process, and certainly before selecting an annuity.
Tax and retirement planners can help you determine which tax preferences suit your portfolio, health circumstances and income timelines in the most beneficial manner to you. And then you will feel safe in choosing the annuity that best serves your situation.
2. Heather L. Schreiber, RICP
– For Financial Professional Use Only.
Insurance-only agents are not licensed to offer investment advice.