By Justin Fundalinski, MBA | April 25, 2017
Annuity income can play an important role in retirement planning because if used correctly, it can provide a steady stream of income for the rest of the annuitant’s life. However, while steady and secure income simplifies finances for annuitants (especially as they age), understanding how annuities are taxed becomes a bit more complex (not that you would ever have to figure it out on your own since the insurance companies will always report to you what is taxable, but good to know nonetheless). In this month’s article I focus on how different annuities are taxed.
How is my annuity IRA going to be taxed?
This is the easy one! All qualified annuity payments (annuities that fall under the umbrella of an IRA, Roth IRA, or other tax deferred retirement account) will be taxed in the exact manner that they would be taxed in any other qualified account type. For example, Traditional IRA annuity income is taxed as ordinary income just as if you took a distribution from your IRA investment account. Or, Roth IRA annuity income is tax free income just as if you took a distribution from any Roth account.
Is a non-qualified annuity taxed differently?
Non-qualified accounts (or often referred to as “taxable accounts”) are accounts that don’t fall under the qualified retirement account category discussed above. These are accounts like your bank account, or an individual/joint investment account. When an annuity holds onto non-qualified funds the taxation is substantially different than non-qualified funds in other types of accounts.
Here are some of the basics of taxation while the funds are inside of the annuity:
- The annuity grows tax-deferred. Unlike non-qualified accounts that often generate taxable income via interest, capital gains, or dividends, a non-qualified annuity does not subject the owner to taxes until the funds are removed from the account. When the gains are removed they are taxed as ordinary income.
- There is no step-up in cost basis at death. Unlike other non-qualified accounts that allow beneficiaries a step-up in basis and essentially avoid embedded capital gains on their inheritance, all the deferred earnings in a non-qualified annuity are taxable as ordinary income to the beneficiary. This rule applies to all non-spousal beneficiaries, but depending on the policy a surviving spouse may be able to retain the continued tax-deferred growth.
How is my income from non-qualified annuities taxed?
Income generated from a non-qualified annuity is taxed differently depending on how the income is being received. Income can be received essentially in two different ways; either, a stream of annuity payments, or as withdrawal from the annuity. This usually generates a bit of confusion so I will dive into a little.
Annuitized Payments
When an annuity is actually “annuitized” you lock in a stream of income payments and you lose the ability to access the cash value of the account. The keyword here is lock. Once annuitized you cannot withdraw any less or more than what the insurance company sends you and have absolutely no ability to close the account and take your principal back.
The taxation on these payments is fairly straight forward. First, the insurance company will determine something called the “exclusion ratio” which determines the percentage of each payment that will be excluded from income tax (essentially the percentage of premiums that you paid compared to the account value at annuitization). Any income that is not excluded from tax will be taxed as ordinary income and will not receive any special tax treatment as dividends or capital gains may. However, if the annuitant lives longer than the actuarial life expectancy which means all premiums/basis will has been received back) then 100% of the payments become subject to ordinary income taxes. To recap this, initially part of each payment is taxed while part is not, and eventually (if you live long enough) all of it is taxed.
Withdrawals
Withdrawals are a little sticky regarding taxation and some riders called “guaranteed withdrawal benefits” are often confused with annuitization. So, let’s try to keep it as simple as possible. All withdrawals from a non-qualified annuity force you to take your gains first, and then your premiums are returned to you. So for example, if you put $50,000 into an annuity and it doubled in value to $100,000 then when you start taking withdrawals from it the first $50,000 withdrawn would be taxed as ordinary income while the last $50,000 would be tax free return of principal.
Guaranteed Withdrawal Benefit
Now, if you have a “guaranteed withdrawal benefit” the insurance company guarantees that you can begin withdrawing a certain percentage of the annuity for the rest of your life. Sounds like annuitization right? Wrong! The rules of “guaranteed withdrawal benefits” blend the rules of withdrawals and annuitization.
Let’s continue the example above. $50,000 goes in, it grows to $100,000, and now a guaranteed withdrawal benefit of $10,000 per year for life begins. How does this get taxed? First, it gets taxed just like the simple withdrawal scenario did as explained earlier; earnings come out first, then a return of principal. But in this case, the account eventually reaches zero and you are no longer able to withdraw funds from this account. However, with guaranteed withdrawal benefits, once your account reaches zero your annuity technically becomes annuitized. Since all premiums have been received back, 100% of the payments become subject to ordinary income taxes until death. So if you took that all in and are a little confused think of it like this, first you’re taxed, then you’re not, then you are!
As always, this is a 30,000 foot view on the taxation of annuities. There is a lot more details and depth on this topic but these cliff notes should give you a good start on understanding it. If you have any questions please feel free to contact us at the office.
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