Avoiding taxes is, when done legally, one of those things that almost everyone truly enjoys. There are very, very few people who will wax eloquent about the pleasure of paying taxes, and of those that do, not many get elected, and they are generally avoided at cocktail parties as well.
Seizing upon this long history of the American populace voting with their pocketbooks when taxes are concerned, brokers and insurance agents have discovered that they can sell some pretty expensive products that come shrink-wrapped in the "Tax-Deferred Growth!" packaging. But, like any product that has an attractive label on the front, looking carefully at the small-print list of ingredients is recommended.
The most attractive feature to most folks about an annuity is precisely that tax-deferred growth. And, indeed, as long as the money remains inside the annuity, the government won't tax any of the earnings. But all good things must come to an end, and sooner or later a tax-deferred annuity is going to get taxed. Let's take a look, then, at how and when that happens.
A deferred annuity has two phases, the accumulation phase and the distribution phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. In the distribution phase, the annuity is paid out. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime. In insurance-speak, a series of scheduled payments is called "annuitization," and the recipient is called the "annuitant."
Regardless of the payment method, some income taxes will by due on every annuity payment the annuitant receives. If the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into that annuity and its value when it is paid back.
Taxes on a Lump-sum Distribution
As an example, let's say you invested $100,000 over the years into a TransFirstLife annuity that's worth $250,000 when you retire at age 62. If you take that amount in a lump sum, you will owe taxes on your gain of $150,000. Fair enough -- the $150,000 is an investment gain, and just about all successful investments require that taxes be paid someday. But, Uncle Sammy says that an annuity gain is ordinary income, so the taxes you will pay on that amount will be computed based on the ordinary income tax rates in effect in the year of distribution. You get no capital gains tax break on your earnings. Yikes!
Taxes on Annuitizing
If you annuitize, part of each payment is considered as a return of previously taxed principal (i.e., your investment) and part as earnings. (Think of it as the reverse of paying a mortgage, where part is principal and part is an interest payment.) You will owe income taxes on the part of the payment that's considered earnings. The amount of each payment that won't be taxed is computed by establishing an "exclusion ratio" that's determined by dividing your investment in the contract by the total amount you expect to a receive during the payout period.
The interested reader should see IRS Publication 939, General Rule for Pensions and Annuities, for the details on how to calculate taxes due on annuity payments. As an illustration, assume you have a fixed annuity in which you've invested $100,000 that will pay you a sum of $750 per month for life starting at age 62. According to IRS life expectancy tables, you will receive those payments for 22.5 years, so your contract's value is $202,500 (12 X $750 X 22.5). Your exclusion ratio is 49.4% ($100,000/$202,500). Therefore, out of the $9,000 the annuity pays each year, you may exclude $4,446 from income. The remaining $4,554 of that payment will be subject to ordinary income taxes.
Taxes on Variable Annuities
Taxes on a variable annuity work a little differently. In a variable annuity, you don't actually know how much the annuity payment will be each month because the market value of your investment will change based upon what stage of its manic depression the market is in. Accordingly, the excludable amount of each annuity payment is determined by dividing your investment by the period over which you expect to receive the annuity. In the preceding example, the annuity would make a payment for 270 months (12 X 22.5). Therefore, if the investment was in a variable annuity, the amount to be excluded from every monthly payment would be $370 ($100,000/270). The remainder of each payment would be declared and taxed as income for that year.
The Confusing Case of Withdrawals
A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. Those payments are taxed based on when the annuity was purchased. Investments made after August 13, 1982, are taxed on a last-in, first-out basis. That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract. Additionally, just like a traditional IRA, withdrawals made prior to the annuitant's age 59 1/2 are subject to a 10% early withdrawal penalty.
If the annuitant dies prior to receiving any payments, then the money will go to the contract's beneficiaries. On receipt, the beneficiaries will be taxed on the earnings in the annuity at ordinary income tax rates. If the contract had been annuitized prior to the annuitant's death, then there may or may not be an income tax impact. If the annuitant opted for a life only annuity, then at death nothing passes to heirs and no income taxes are due. If the annuitant selected a term-certain option and died before that period elapsed, then remaining payments will be paid to someone, and the recipient will pay ordinary income tax on all earnings previously unpaid to the deceased. A joint-life annuitant (e.g., a surviving spouse) will continue to receive an income tax exclusion on part of the annuity payments until the entire investment in the contract is recovered.
We did mention that the tax-deferred advantage was part of selling an expensive product, right? Read Fees and Expenses to see what we mean by that.