An annuity is both a contract with an insurance company and an investment. Your contributions (often called premium payments) to it are invested to produce earnings. This article explains when and what is taxed as income under annuitization, withdrawals, and gifts of your annuity.
An annuity has two phases: accumulation and annuitization. During accumulation - called a deferred annuity - both your contributions (i.e. premium payments) and their earnings accumulate within the contract. During annuitization (i.e. payout stage) you receive monthly payments while money remaining in the contract creates more earnings.
Most annuities are nonqualified. You can make unlimited after-tax contributions to them and their earnings grow tax-deferred. Only the tax-deferred earnings are eventually subject to income tax; your contributions come out tax-free as a return of your basis in the contract.
A qualified annuity is one regulated under government rules as a retirement plan. All contributions to them are deductible from income but, of course, must come from working income.
Annual contributions are limited like IRA contributions. Since they have no after-tax contributions, your tax basis in the contract is zero; so all withdrawals will be subjected to income tax.
Like all qualified plans, any withdrawal you make before reaching age 591/2, will have a 10% penalty tax imposed on it in addition to income tax. After reaching 701/2, you're required to make minimum required distributions - just like IRAs.
Income taxation is imposed on:
* Annuitization
* Accumulation withdrawals
* Gifts of an annuity, and
* Beneficiary's withdrawals
Let's see how nonqualified annuities are taxed:
Taxation on annuitization payments:
Your monthly payouts are considered as made up of a contribution part and an earnings part. Only the earnings part is taxed as income. It's a specific fraction of your payment equal to total earnings divided by the contracts total value - i.e. earnings plus contributions. After you've received all your contributions back in payouts, all future payouts are fully taxed as income.
Taxation on withdrawal from your deferred annuity accumulation:
Taking money out of your deferred annuity is a withdrawal. But earnings are considered to come out first. So anything you withdraw is taxed as income until all the earnings are out. Any withdrawal beyond earnings is a tax free return of basis.
Until you've turned 59 years old, the IRS imposes a 10% penalty tax on what you take out of your nonqualified annuity too.
This withdrawals taxation also includes cashing out your deferred annuity altogether. An early cash out may trigger an additional fee from the annuity company.
Taxation on a gift of your deferred annuity:
Gifting your deferred annuity to a person, charity or a charitable remainder trust, triggers income tax on the annuity's earnings; that includes any 10% penalty tax too.
For gifting to a government-approved charity, your deduction is limited to your basis in the contract - i.e. the sum of your contributions.
Qualified annuities are taxed as above accept they have no basis - i.e. basis equals zero.
Taxation on beneficiaries and survivors:
Annuities that go to beneficiaries and survivors are considered as 'income in respect of a decedent' - and not as an investment. So an annuity - unlike an investment - doesn't get a stepped-up basis.
So, any annuity payout to survivors and beneficiaries is subject to income tax - but only to the extent that money paid out to them exceeds the annuity's basis -i.e. the original owner's annuity contributions. So a portion of each payout will be attributed to the deferred tax on the earnings of those contributions and a portion will be return of basis.
As it was for the original owner, when the basis has been completely recovered through payments to the beneficiary, all further payments will be fully taxed as income.
Shane Flait writes and consults on financial, legal, tax, and retirement issues. He gives you workable strategies to accomplish your goals.
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