Annuities - Tax Implications
Annuities can be a good choice for savers looking for both a tax-deferred investment now and a steady income stream in retirement.
Annuities are a popular way to guarantee a steady flow of income for retirees, but they also function as a safe vehicle for tax deferral. Consumers in a high income tax bracket may want to consider an annuity as part of their portfolio of investments.
Phases of Annuities
The first phase, known as the accumulation phase, occurs while a consumer regularly invests savings in an annuity managed by an insurance company. The second phase is the pay-out phase, which begins when the annuity reaches its term. Funds can be paid in a lump sum or in installments. Annuity investors can choose a set time such as 20 years, or have the payments continue over the life of the investor or the investor and his or her spouse.
Types of Annuities
Both fixed and variable annuities are available from insurance companies. For a fixed annuity, an insurance agency guarantees a minimum rate of interest during the accumulation phase and guarantees that the payments will be a certain amount per dollar invested during the distribution phase.
A variable annuity allows the investors to choose among a range of investment options, usually mutual funds. The rate of return during the accumulation phase and the size of the payments during the distribution phase will depend on the performance of those investments.
Many annuities include a death benefit which means that the investor's beneficiaries will receive the greater of either a guaranteed minimum death benefit or the total of funds in the account upon the investor's death.
Tax Implications of Annuities
While taxes are deferred during the accumulation phase of annuities, the distributions are subject to tax. For investors who opt for a lump sum payment, the general rule is that the tax is calculated on the basis of the difference between the amounts paid into the annuity over the years and the final amount of the annuity including accumulated interest and dividends.
• Taxes on a Lump Sum Distribution: If you regularly made payments to the insurance company which handles your annuity for a total of $80,000, that annuity, upon your retirement, could be worth $135,000.00. The IRS will consider the $55,000 difference as ordinary income subject to taxes rather than as a capital gain.
• Taxes on Installment Payments and Variable Annuities. If you receive your annuity pay-out in installments, taxes must be paid on each installment according to formula established by the IRS. Taxes are owed on the difference between the amount invested and the amount of the monthly payments. 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. For variable annuities, the amount of each annuity payment excluded from taxes is determined by dividing your investment by the period over which you expect to receive the annuity.
IRS Publication #939 covers the rules on Pensions and Annuities, but investors should also consult an accountant or tax advisor for advice on the tax implications of annuities.