Fred Orentlich on Taxation of Annuities

Discussion in 'Articles & Tutorials' started by fredorentlich, Sep 6, 2011.

  1. fredorentlich

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    Aug 29, 2011
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    Hello I am Fred Orentlich and I will be talking about annuity taxation. Many people know that annuities are tax deferred investment vehicles that allow them to accumulate returns on their money each year without having to claim taxes on the returns. This is the major benefit of a tax deferred annuity. If you have a long period of time to build your assets before retirement this is a good way to do it. One of the major things to think about with an annuity is that your purchase premium will be made with after tax money.

    It is the same as if you were investing in a CD or a mutual fund. Your initial investment is not tax deductible on your income tax return. Annuities are purchased with after tax money. The only exception to this is if you are purchasing an annuity as part of an IRA or other tax qualified accounts. However, the money earned on an annuity is not taxed until you take it out. This allows the money to grow at an accelerated rate than it would otherwise.
    Lump Sum Withdrawals

    If you are going to take a lump sum withdrawal from your annuity, you will be taxed on a LIFO accounting cycle. This stands for last-in-first-out. In other words, your distribution will be considered earnings first and principal last. If you take only a partial withdrawal as a lump sum, you may pay ordinary income taxes on the whole amount depending on what the total earnings of the account are. This is true whether you have a variable annuity, a fixed annuity or an indexed annuity.

    If you have not reached the age of 59 1/2 yet, you may also pay a 10% early withdrawal tax. This tax is waived if you have become disabled, or if you take a systemic withdrawal for a set number of years. Thoroughly understanding the taxation of annuities is critical before setting in motion your retirement plan.

    Periodic Payments

    Some annuity contracts which have guaranteed minimum benefit riders will allow you to take regular monthly payments or regular annual payments without annuitizing your contract. These payments are taxed on the LIFO basis also, which means that your payments will be taxed as ordinary income until you have exhausted the gains and after this, your distributions will be considered return of principal and will not be taxed.


    If you decide to annuitize you annuity payments, your regular distributions will be taxed as part principal and part interest or earnings. This is based on an Exclusion ratio. This takes into account the amount you paid in and the earnings. Keep in mind that when you annuitize you are basically giving up any potential for other distribution options. You will not be able to take any more partial distributions or change anything. You are in effect giving your asset to the insurance company for the promise of income for life or for a period certain.
    Taxation Advantages of Annuities

    As mentioned earlier, capital gains and interest earned on annuities is tax-deferred. If you are invested in a variable annuity and the stock market has done well, you can get multiple benefits because you have not had to pay the taxes on the gains you have made each year. The mutual funds that you have been invested in have probably declared capital gains and dividends but you don't have to declare them because you are inside of an annuity. If you have a fixed annuity or an indexed annuity that pays a set minimum rate, you are able to compound the interest rates you money makes by not having to declare the interest each year.

    If you decide that another company has been doing better or has more benefits than your current annuity company has, you can do a tax-free 1035 exchange of your annuity. This means that you can exchange your annuity for the new annuity without having to pay taxes on any gains. You should check to see if you will have surrender charges from the annuity company before leaving. Also, you should compare the surrender period on the new contract.

    Compared to investing outside of an annuity in a CD instead, each year you will have to pay taxes on the interest earned. For example if you invest $100,000 in a CD at 4% interest, you will earn $4,000 for one year. At the end of the year you will declare the $4,000 as income and pay taxes on it. If your tax bracket is 30%, you will pay $1,200 in taxes and the remainder: $2,800 can go back into the CD. If you get 4% on an annuity of $100,000, the whole $4,000 continues to earn interest. The benefits of compounding interest over a number of years increases, and can really add up during the course of a career. You should take advantage of this, if you have time.

    Cases Where Annuities Will be Taxed

    If you transfer ownership of an annuity to another person, you will be taxed on the total amount of the gain in the account. You will pay ordinary income taxes on any amount of increase the value whether it is interest or growth. This is because you in effect took access of the money to give it to someone else.

    If the annuity owner passes away, the beneficiary will receive the death benefit proceeds income tax free. However, annuity benefits are not estate tax free. They are included for determining estate taxes. You will have a certain amount of estate tax exclusions so check what these are at the time. If you have your spouse named as beneficiary, upon your death, your spouse may continue the same annuity payments. He/she can then name a new beneficiary to the contract, like a child or grandchild. This will let the death benefit transfer income tax free again. It is important to understand the taxation of annuities thoroughly when calculating your retirement savings needs.

    There are times when people use annuities as a method for investing their IRA or other tax sheltered money. The reasons for doing this are to take advantages of some of the annuity contract’s living benefits. When taking distributions from a tax qualified account, all the money withdrawn is taxed as ordinary income, because it was never taxed to begin with.

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