Are Annuities Taxable
It’s difficult to address a topic such this and avoid the tired, old cliché, “the only certainties in life are death and taxes.” So, we won’t try. The fact of the matter is that there is no investment vehicle that is completely tax free. Even with tax exempt bonds, the income received can increase the amount of taxes paid on your Social Security payments. You can pretty much count on the fact that the IRS always wants to collect its share and annuities are no different. The earnings from annuities, while not currently taxable, are taxed as ordinary income when they actually received. A primer on annuity taxation is helpful for understanding both the tax advantages and the tax consequences.
Annuity Tax Essentials
The tax treatment of annuities can be viewed through their two distinct stages of accumulation and distribution. Both stages provide for tax advantages and tax consequences, and, with some fundamental knowledge, investors can maximize the advantages and minimize the consequences.
Accumulation: Tax Deferral
Deferred annuities, so named because the income or distribution stage is deferred until some point in the future, allow your funds to accumulate over time without having to pay current taxes on the earnings. Whether the funds grow at a fixed rate (as in a fixed deferred annuity) or at variable returns (as in a variable annuity), their earnings are not reportable as income. For people whose income falls within the higher income tax brackets, this can be quite an advantage in achieving faster accumulation. For someone in a 50% combined federal and state tax bracket, that means that half of the earnings that would otherwise have to be paid to the IRS are left in the account to grow. The compounding of tax deferred earnings over time can have a significant impact on the growth of your funds.
Because they are only deferred, the taxes will come due eventually when the earnings are actually received. At that point, they are taxed as ordinary income. Because you are able to control how much of the earnings are withdrawn, you are then able to control how much in taxes you will pay in any given year. If you need to access your funds before you turn 59 ½, you can expect to pay an extra 10% on top of the tax as a penalty. A penalty is not applied if your withdrawal meets certain conditions, such as funding a disability.
Income Distribution: Partially Tax-Exempt
When a deferred annuity is converted into an income annuity, or if an immediate annuity is purchased for the purpose of generating immediate income, your lump sum of capital is committed to a life insurer that then commits to an income payment schedule. Essentially, the insurer calculates the amount of income your lump sum of capital will generate for a specified period of time. If your income need is for your lifetime, the number of payment periods is based on your life expectancy. The income payment is calculated by dividing the capital amount by the number of periods factoring in interest paid on the balance. The calculation will result in an income amount that will deplete both the capital and the earnings in the specified time frame. The insurance guarantee of a lifetime annuity provides that the income will continue even if you surpass your life expectancy age.
Because your income payment is a combination of your original capital and your earnings, only the portion that is earnings will be taxed. Your principal is not taxed. The shorter the distribution stage, or the fewer the number of payment periods, then the larger the principal portion of your income payment and the less tax you will owe. This is why it is often recommended that you delay annuitization as long as you can, to shorten the payout period. Because you are only paying taxes as the earnings portion of your income payment is received, you are, in effect, deferring taxes further into the future.
The good news is that income received from annuities is not included in the Social Security income tax calculation which can be an advantage over tax exempt bonds. That would depend on your tax situation at retirement.
Annuity Taxation at Death
One of the distinct features of annuities is their guaranteed death benefit. Your beneficiaries are assured of receiving your principal investment at a minimum and, most annuities, your gains are also guaranteed to be passed along. But, again, the IRS is waiting patiently to collect its share, so when the death benefit is paid, the earnings are taxed as ordinary income to the beneficiary. If the annuitant dies while receiving income, and an installment refund option was selected, the beneficiary owes taxes as the earnings are received.
Additionally, the full value of the annuity is included in the estate of the annuity owner which may result in estate taxes if the total value of the estate exceeds the exemption level. The good news is that annuity proceeds are excluded from probate proceedings, so at least they can be quickly transferred without adding to the legal costs.
Annuities are popular largely due to the deferral of taxes on earnings. Unquestionably that can put people in higher tax brackets further ahead in the accumulation of retirement savings. But, the tax man will eventually call, so it is important to weight the tax consequences at the time of withdrawal or income. And, it is also important to alert your beneficiaries of the tax consequence at death so there are no surprises. Because annuities do involve tax issues, it is always recommended that you consult with a qualified tax professional when considering an investment.