Financial Advisor
How Do Governments Tax An Annuity?
One of the key advantages of annuities is that they’re allowed to grow while putting off taxes until later. But that doesn’t mean policy holders can ignore Uncle Sam forever. And the way these vehicles are eventually taxed is often complex and misunderstood.
Qualified Versus Nonqualified Annuities
In general, annuity owners don't pay any taxes until they take their money out (unless the owner is a corporation or trust; nonhuman owners must pay taxes on the annuity's growth every year). Yet the amount of tax due depends a number of factors.
One of those is how the annuity is owned. If you purchased it with pre-tax dollars—as part of an IRA, a 403(b) or a similar tax-advantaged retirement account, for example—it's considered a "qualified" account, and the payments are fully taxable as ordinary income. On the other hand, if you bought the annuity with after-tax dollars, and not as part of a retirement account, it's considered "nonqualified" and only the net gain—the earnings or growth—is taxable, not the money you initially invested (also known as the cost basis).
"Income from a nonqualified annuity will be partly taxable and partly non-taxable, based on the cost basis," says Michael J. Zmistowski, a personal financial planner in Tampa, Fla.
The ordinary income tax rate applies whether it's a variable or fixed annuity. But calculating how much of each nonqualified annuity payout counts as taxable net gain and how much as part of the tax-free cost basis can be tricky.
"Nonqualified annuities with income riders are taxed using the last-in-first-out (LIFO) method," explains Joanne Lam, senior vice president of wealth management at Freedom Capital Management in Holmdel, N.J. "All earnings from the income rider are distributed first and are subject to ordinary income tax. Once the earnings are fully withdrawn, the remainder of the distributions are from the initial principal and are not subject to tax."
That is, distributions that exceed the annuity's net earnings are considered a return of the cost basis, and are thus tax free.
The Exclusion Ratio
If, however, the distribution from a nonqualified annuity does not come from an income rider but instead from a partial annuitization of the contract, the taxable portion of the payout is subject to a slightly more complex formula. Such contracts "follow a different calculation to determine the taxable portion of the income stream," says Todd Giesing, assistant vice president and annuity research director at the Secure Retirement Institute in Windsor, Conn. "This is called the exclusion ratio, and it simply calculates out a portion of income payout that would be gains under the assumption of predetermined mortality."
To put it another way, the exclusion ratio is based on the contract's expected return, which in turn is based on an annuitant’s life expectancy and age when he or she purchased the contract. Annuitants can calculate the ratio as the cost basis divided by the number of expected years they have left when they buy the annuity (according to the insurance carrier's mortality tables). So someone who buys an annuity at age 85 may have payments that are largely tax-free, whereas "if you get a quote for someone who is younger—say, 50—more of the payment would be taxed," says David Blanchett, a managing director and head of retirement research at QMA, a quantitative equity and multi-asset solutions specialist.
Tim Rembowski, vice president of member success at DPL Financial Partners in Louisville, Ky., says, by way of example, "If you owned [an annuity with a $100,000 cost basis] and you were determined to have 20 years left on the actuarial table, then $5,000 of each payment would be tax free. Any amount above the $5,000 would be taxed as income."
The exclusion ratio also takes into account the income option you select—whether it’s lifetime payments, payments for a set number of years, or joint-life payments in which a surviving spouse receives the benefits after the account holder's death. "All of which," says Michael Harris, senior education advisor at the Washington, D.C.-based Alliance for Lifetime Income, "help determine your monthly income check. The insurance company will provide a 1099 at the end of the year with all the associated tax information."
A Tax Planning Tool
A key advantage of the exclusion ratio is that it allows you to "spread out the taxes until the basis is exhausted," says Gary Schwartz of Madison Planning in White Plains, N.Y.
This can be "a powerful tax planning tool to reduce the impact of taxes on distributions," says Laird Johnson, senior director of advanced markets at Equitable in New York City. He adds that the exclusion ratio is often mistakenly thought to apply only to fully annuitized contracts. "Some products allow for partial or term-certain annuitizations that provide the tax benefits of the exclusion ratio without full annuitization," says Johnson.
Annuitization Disadvantages
If all of the principal is paid out, any additional distributions are taxed as ordinary income. Similarly, if the annuitant outlives his or her life expectancy, all payouts thereafter are taxed as ordinary income, too.
"The disadvantage of doing an annuitization is that once you annuitize, the election is irrevocable, and most contracts don’t have a cost-of-living adjustment rider," says Luis Strohmeier, a partner and wealth advisor at Octavia Wealth Advisors in Miami. "So once you make the election, it’s the same income amount [for the contract's term]. This is in contrast to a withdrawal rider, which is not an irrevocable election and can be simply withdrawn from the account value."
Inheritance
When the contract owner dies, the heirs will be taxed on distributions in the same ways. But for nonqualified annuities, non-spousal beneficiaries "are required to begin taking distributions … within one year of the original owner’s death," explains Eric Henderson, president of Nationwide Financial’s annuity segment in Columbus, Ohio. "If the beneficiary does not take the required amount within one year … they have five years from the date of the owner’s death to liquidate the entire inherited annuity," he says. (Spouses who inherit nonqualified annuities "may continue the annuity in their own name and are not required to take distributions," says Henderson.)
If the non-spouse beneficiaries do take the required withdrawal in the first year, though, they can spread out remaining payments—and, therefore, forestall taxes. "Under current tax law, a beneficiary of an annuity can opt to stretch payments over many years, based on the beneficiary’s life expectancy," says Todd Hall, director of financial planning at Homrich Berg in Atlanta. "This was previously available for those inheriting an IRA as well, but recent tax law changes eliminated that option."
On the other hand, if it's a qualified annuity, non-spousal beneficiaries must withdraw all funds within 10 years. The tax rules on those withdrawals are the same, but the extra time should be enough to "manage how to efficiently take the distributions out so they're not all taxable at once," says Ben Barzideh, wealth advisor at Piershale Financial Group in Barrington, Ill. "If they don’t take anything out for the 10 years … then at that 10th year they have to take a full distribution of the amount and what it has grown to. That could be a tax disaster."
The inheritance rules do not apply if the annuity is gifted to someone (other than a charity) while the original owner is still alive. Such transfers trigger a taxable event for the donor.
Legacy Planning
With an inherited annuity, there is no "step up" in the cost basis, as there would be for long-held stocks or real estate. Yet Brandon Buckingham, vice president of advanced planning at Prudential Financial in Boston, points out that annuities "can have several benefits from a legacy planning perspective."
One advantage he cites is that they aren't subject to probate and the associated expenses and delays. Beneficiaries can defer taxes by not completely cashing in inherited annuities all at once. And many annuities offer enhanced death benefits, which work like life insurance.