One of the biggest impediments to accumulating wealth is the income tax which is why investors are drawn to investments that can help minimize or avoid them. This is the reason why annuities have had such great appeal for investors over the years, as it is one of just a couple of investment vehicles that enjoys favorable tax treatment by the U.S. tax code. Understanding how annuities are taxed would be important for any investor who seeks to maximize returns by minimizing taxes.
Annuity Tax Basics
There are essentially two stages to an annuity contract: the accumulation stage and the income distribution stage. Both stages have specific tax rules that apply.
Accumulation Stage Taxation
All annuities have an accumulation account in which earnings are generated from interest rates (fixed annuities), or from investment returns (variable annuities), or based the actual movements of stock indexes (indexed annuities). No matter how the earning are generated, the taxes owed on them are deferred until they are withdrawn, at which time they are taxed as ordinary income. Because withdrawals from annuities are deemed to be earnings first, and then principle, they are taxed until the earnings portion is depleted. There are no taxes on the withdrawals of principle.*
In return for the favorable tax treatment of earnings, the tax code specifies certain requirements that must be met. The primary requirement on withdrawals is that they cannot be made prior to the age of 59 ½ without incurring a 10% penalty on the withdrawal amount. If an annuity owner “annuitizes” an annuity prior to age 59 ½, that is, when the annuity is converted into a serious of equal, periodic payments for life, the 10% penalty is waived.
Income Distribution Taxation
At the time an annuity is annuitized, the account balance is turned over to the life insurance company to convert it to a stream of income. The income payments are determined by calculating the number of periodic payment, the amount of interest that will be earned in that period and then dividing the account balance plus the future interest earnings by the number of period payments. The result is an income payout that consists of both principle and interest in which the principle is excluded from income taxes. The remaining interest portion is taxed as ordinary income.
Annuity owners who are younger than 59 ½ can avoid the withdrawal penalty by simply annuitizing their annuity to receive equal, periodic payments over their life expectancy.
One of the advantages of annuity income is that it is not factored into the income calculation of Social Security taxes.
Taxing Annuity Death Benefits
If the annuity owner dies during the accumulation stage, a designation beneficiary will received the annuity account value as a death benefit. Unlike, life insurance death benefit proceeds, which, in most cases, are not taxable to the beneficiary, proceeds from annuity death benefits are includable as ordinary income to the extent that they are earnings. Additionally, the proceeds are included in the estate of the deceased annuity owner.
If death occurs during the distribution stage, after annuitization, and a refund option was selected, the portion of the refund that is comprised of earnings will be taxed as ordinary income. In the case where the deceased annuitant has a spouse, he or she would continue to receive the annuity payments and pay ordinary income taxes on the earnings portion.
Annuities provide tax conscious investors with the opportunity to accumulate their assets faster through the tax deferral of earnings. The deferral of taxes can be extended if the annuity is converted to income, and, when planned properly, the income can also be taxed minimally.
The biggest tax disadvantages of annuities it their treatment upon withdrawals when they are taxed as ordinary income. This, as compared to redeeming mutual fund shares which may be taxed at the more favorable capital gains tax rate. Additionally, the death benefit proceeds present a double whammy to the beneficiaries in that they are both taxed as ordinary income and they are included in the estate tax calculation.
Used in the proper context of a long term retirement plan, the tax advantages of annuities will outweigh any potential disadvantages.
*Annuities purchased prior to August 13, 1982 are considered to be “first in-first out” which means that the initial withdrawals come from the principle and are, therefore, not taxed.