Annuities – Tax Implications
Annuities were not created solely to provide retired or semi-retired individuals with a regular income stream. A second important feature of annuities is that of tax deferral. People who are in a high income bracket and who could use an efficient tax-deferral scheme arrangement are looking at annuities as a way of easing their tax burdens every year.
To better assess the tax implications of annuities, buyers of annuities must be aware that an annuity goes through two phases. The first is the accummulation process –this is an individual’s saving years. He puts money regularly into his annuity until it’s time to withdraw his funds. The second is the distribution phase. When an annuity reaches its term, the funds are paid out to the annuity owner either in one lump sum or in fixed installments with a pre-established timeframe. These installments or payouts constitute the annuitization. The owner then becomes an annuitant.
The payouts – or distributions if you will – are subject to tax. Every time a person receives a payment from his annuity, he has to pay taxes. If he opts for a lump sum payment, the general rule is that the tax is calculated on the basis of the difference between the amounts paid by the annuitant over the years and the final amount of the annuity. We’re assuming here that the annuity accummulated either interest or dividends.
- Example of Calculation
Taking a fixed annuity as an example: let’s say you regularly made investments amounting to $80,000 throughout your working life to X insurance company. When you retired, that investment was worth $135,000.00. The difference then is $55,000.00. As far as the IRS is concerned, you need to pay taxes on that $55,000 – evidently an investment gain. The problem is this: the IRS will consider this $55,000 as ordinary income and hence is subject to taxes. You can’t take advantage of a capital gains tax break.
Due diligence is recommended. Familiarize yourself with IRS publication # 939 which deals with the rules covering Pensions and Annuities. You’ll probably be turned off by some terminology like expectancy tables, contract value, exclusion and other such terms. A few years before your actual retirement, ask your accountant or lawyer about this publication and have him explain the sections that are not clear to you.
Variable annuities are taxed differently. The term suggests that because the annuity is variable, you won’t know the monthly payments you will receive from the insurance company because these values will fluctuate with the market. So for tax purposes, you need to determine the excludable amount. This is calculated by dividing your investment by the number of months in which you will be receiving annuity payments. You’re therefore dealing with two amounts here: the actual amount and the excludable amount. The difference between these two amounts is the amount that’s taxed.
- Tax-Deferred Annuities
You’re probably wondering how you can benefit from the tax-deferral scheme of annuities. These are the 403(b) and the 457(b) plans. It is a retirement plan that allows certain employees to have amounts deducted from their salary which go into a tax-deferred plan. By doing this, they reduce their income and pay lower taxes. They can defer taxes well up to their retirement. Because taxes are “postponed”, people with this type of annuity can make their money work harder for them.