Taxation of Annuities Flashcards
Is the Accumulation Stage Tax-Deferred in annuity?
Interest that accumulates in a deferred annuity is not taxed while the funds remain in the annuity. In other words, the accumulation is tax-deferred. As long as it remains in the annuity, earnings are not taxable.
This is one of the main tax benefits offered by annuities If money is withdrawn from a deferred annuity during the accumulation stage (that is, before annuitization), there are income tax consequences.
Distributions During Accumulation Stage
Deferred annuity withdrawals are treated on a “last-in, ________” basis, which means withdrawals are treated first as a ________ interest.
Are interest earnings taxed at ordinary income rates or at capital gains rates?
Deferred annuity withdrawals are treated on a “last-in, first-out” (LIFO) basis, which means withdrawals are treated first as a taxable distribution of interest.
After all interest earnings have been withdrawn are subsequent withdrawals treated as a distribution of nontaxable premiums.
Since the premiums were funded with after-tax (not tax-deductible) dollars, they are not taxed when withdrawn.
For example, assume Clyde bought a single-premium deferred annuity ten years ago. He paid $25,000. Today, the contract’s value is $46,000. The contract owner’s cost basis is $25,000; the interest earnings are $21,000.
Annuity interest earnings are taxed at ordinary income tax rates, not capital gains rates.
Annuity Withdrawals Before Age 59½ incurs what penalty tax?
When is this penalty not imposed?
To encourage the use of annuities for long-term retirement savings and discourage early withdrawals, a 10 percent penalty tax is imposed on withdrawals before age 59½.
If the annuity contract owner withdraws money from the annuity before age 59½, then the taxable portion of the withdrawal is charged a 10 percent tax penalty in addition to the ordinary income tax paid on the earnings distribution.
There are three situations in which a withdrawal from an annuity before age 59½ will not be penalized with the 10 percent tax:
- The contract owner dies.
- The contract owner becomes disabled.
- The withdrawal is taken in substantially equal payments over the owner’s life.
During the Payout (Annuitization) Stage what portion is taxed and which is not?
When a deferred annuity is annuitized (or an immediate annuity is bought), the periodic payments it generates for the annuitant or the beneficiary consist partly of principal and partly of interest earnings.
Here, too, the interest portion is taxed and the principal is not. Determining the split between taxable interest and nontaxable principal in an annuity payment is achieved through the exclusion ratio.
The Exclusion Ratio identifies ….
How do you calculate the ratio?
The exclusion ratio identifies the portion of an annuity payment that is excluded from tax.
investment in the contract / expected return (annual income expected at annuiitization) = amount excluded from income tax
The investment in the contract is the sum of premiums paid into it. The expected return is the annual income received after annuitization multiplied by the annuitant’s remaining life expectancy.
Example of the Annuity Exclusion Ratio
At the age of 40, Lydia bought a fixed deferred annuity with a first premium payment of $20,000. Over the years, she made more payments for a total of $50,000. Today, at age 65, Lydia’s contract is worth $142,000:
$50,000 in total invested premiums
$92,000 in interest earnings
Lydia decides to annuitize the contract under a straight life income option. This would produce $833.30 a month, or $10,000 a year in income. According to IRS life expectancy tables, Lydia is expected to live 20 more years. Therefore, under her straight life annuitized payout option, Lydia’s expected return is $200,000 ($10,000/year × 20 years).
Lydia’s exclusion ratio is calculated as follows:
- $50,000 (investment in the contract= 25 percent (amount excluded from income)
- $200,000 (expected return)
Thus, Lydia can exclude from income tax 25 percent of her annual $10,000 annuity income ($2,500). The remaining $7,500 is the income portion attributed to the contract’s interest earnings and is taxable as ordinary income.
The exclusion ratio applies until all principal in the contract has been recovered by the annuitant tax free. After that, annuity payments are fully taxable. If Lydia lives beyond her 20-year life expectancy, the insurance company will still continue to make annual payments of $10,000. But, at that point, they will be fully taxed.
The annuitant can select a payout option that provides for continued annuity payments to a beneficiary after the annuitant’s death. In this case, the beneficiary will continue to exclude from his or her income the same portion of each payment as originally computed for the annuitant.
Annuity Death Benefits are equal to …
Unlike life insurance the death benefits of annuity are …
Are both principal and interest taxed?
Annuity contracts include a provision to pay a death benefit if the owner dies before the contract annuitizes.
This death benefit typically equals the greater of the contract’s accumulated value or the amount of premium the owner invested.
Unlike life insurance death benefits, the death proceeds from an annuity are taxable to the beneficiary.
Money that is tax deductible going into an asset is usually taxable coming out. Contributions into a qualified retirement plan are generally tax deductible.
On the other hand, 100 percent of all payments are taxable. That is, _the principal is taxable as well as the interest portion of every paymen_t. This is true with annuities used in a qualified plan as well as any other type of asset.
Taxation of Corporate-Owned (Nonqualified) Annuities are annually subject to …
This rule does not apply if the non-natual entity is a …
Annuities owned by non-natural entities (e.g., corporations) are taxed differently than annuities owned by natural persons.
When owned by non-natural entities, the accumulating values in a nonqualified deferred annuity contract are annually subject to current taxation.
Current tax is payable on the annual increase in the contract’s value.
If the non-natural entity is a trust that operates for the benefit of a natural person, this rule does not apply.
Key Points
- Deferred annuity withdrawals are treated on a “last-in, first-out” (LIFO) basis, which means withdrawals are treated first as a taxable distribution of interest.
- Annuity principal (i.e., premiums paid into the contract) is not taxable when distributed.
- The exclusion ratio identifies the portion of an annuity payment that is excluded from tax. The balance of the payment (the portion attributed to interest earnings) is taxable.
- The exclusion ratio applies until all principal in the contract has been recovered by the annuitant tax free. After that, annuity payments are fully taxable.
- Money that is tax deductible going into an asset is usually taxable coming out. Contributions into a qualified retirement plan are generally tax deductible. On the other hand, 100 percent of all payments are taxable.
- When owned by non-natural entities, the accumulating values in a nonqualified deferred annuity contract are annually subject to current taxation.
