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The most
attractive feature to most folks about an annuity is 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 be 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 an 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.
Taxes
on Annuitizing
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 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.
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