Annuity Tax Advantages: 5 Steps to Tax-Free Income

by Rob Phillips, CPA

A qualified annuity is taxed just like any other qualified account, such as an IRA, 401(k), profit-sharing plan, or other tax-deferred retirement account.

A nonqualified annuity is taxed differently from most investments:

  • It grows tax-deferred until withdrawals begin or until the policy is annuitized.
  • It does not provide a step-up in cost basis at death, and the deferred earnings are taxable as ordinary income to a nonspousal beneficiary.
  • Spousal continuation of the policy can often be available to preserve continued tax-deferred growth of the annuity.
  • An annuity is also typically included in your estate for estate tax purposes.

Withdrawals From an Annuity

Withdrawals of earnings taken from a nonqualified annuity are fully taxable at individual ordinary income tax rates. This includes annuity income riders. Unless the annuity was acquired before August 14, 1982, the earnings will be considered withdrawn first and are therefore taxed. All withdrawals are fully taxable as ordinary income until the account value reaches the initial amount invested in the annuity.

Because annuity income is taxed at ordinary ax rates, they do not receive the benefit of lower capital gains tax rates. Also, if you are under 59 ½ years old when you the withdrawal is made, you may be assessed a 10% penalty on the taxable earnings.

Annuitized Payments From an Annuity

When you annuitize a nonqualified annuity, a portion of your payment is considered a return of premium and is not subject to ordinary income tax. The amount that is taxable is determined at the time you elect to annuitize the policy. The insurance company calculates the “exclusion ratio,” which determines the percentage of each payment to be excluded from income tax.

Taxation at Death – Spousal Continuation for an Annuity

Many variable annuity products allow your spouse to continue the policy at your death. Some companies pay the death benefit into the policy and continue the original policy without tax consequences. Others require your spouse to choose either the death benefit (if the account value is lower than the death benefit) or spousal continuation.

Choosing the death benefit in these situations is a taxable event; your spouse is taxed at ordinary tax rates on the difference between the death benefit and the amount that was invested, adjusted for any withdrawals. In most cases, the annuity policy is not included in your taxable estate for estate tax purposes due to the marital allowance. Consult the annuity prospectus for the terms of spousal continuation.

Taxation at Death – Non-Spousal Beneficiary for an Annuity

At your death, the death benefit is paid to the non-spousal beneficiaries you have designated in the annuity contract. This keeps the annuity transfer out of probate. Unlike most other securities and real estate, there is no step-up in cost basis at your death. Instead, any deferred income in the policy is taxable to directly to the beneficiaries as ordinary income at their individual tax rates. You could find that the plan gets overfunded.

When a death benefit is paid out that is greater than the account value of the annuity, the difference between the death benefit and the amount you invested in the annuity, adjusted for any withdrawals, is taxable as ordinary income to the beneficiaries. The value of the variable annuity policy will also be included in your estate for estate tax purposes. Beneficiaries have the choice of taking a lump-sum payment or receiving the payments over time from the annuity, thereby spreading out the income tax liability.

Ways They Can Be Used

An excellent way to supplement the amount you’re putting into an employer-sponsored plan is to purchase non-qualified annuities or, if you’re self-employed, use non-qualified annuities as a secondary source of retirement income. We highly recommend that you make the maximum contribution allowed to your employer sponsored plan before contributing to non-qualified annuities.

Many non-qualified annuities offer greater variety and flexibility than investments you can make in some employer plans; therefore using them is a way to diversify your portfolio that can be very advantageous. For example, if you’re part of an Employee Stock Option Plan (ESOP) that puts your pension money into company stock, you might use non-qualified annuities to put money into other types of equity portfolios. Or if your defined benefit plan will pay you a fixed amount after you retire, you might put money into a variable non-qualified annuity that provides an opportunity for your annuity income to do better than inflation.

More Versatility

The federal government doesn’t require you to begin withdrawing from your non-qualified annuities when you turn 70½, as you must with a traditional IRA and many qualified retirement annuity plans. Some states have no age requirement either, while others impose mandatory withdrawals at some point, generally much later than 70½.

Important: Consult your tax professional for complete information regarding annuity taxation. The tax laws vary from one type of annuity to another.

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