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Annuities are often sold based on the promise that the interest-earning inside of the annuity, prior to turning it into an income stream, grows tax-deferred. No taxes are due on the earnings while the money is held inside of the annuity. However, when the money is taken out of an annuity account that is not producing income, interest earnings become at that point taxable.
Unlike most capital investments, annuity withdrawals are taxed at an ordinary tax rate at the marginal rate of the owner or annuitant. Someone in a 24% tax bracket is going to pay a 24% tax on annuity withdrawals. There is no special capital gains tax rate for annuities. In addition, investors in annuities are penalized for the tax deferral of the earnings. First dollars out are considered earnings and all withdrawals taken up front are taxed at ordinary income until the amount remaining represents the purchase value of the annuity.
This tax penalty has unforeseen consequences for a household wanting to access money from a deferred annuity in their later years. Because all initial withdrawals down to the purchase price, represent ordinary income, this additional taxable income often causes the social security income of the household to become taxable as well -- resulting in a double taxation. Often, the annuity was undertaken in order to accumulate funds for the final years of life. The threat of double taxation can discourage older people from removing money from a deferred annuity when they need it most and they often suffer financially because they fear the sizable tax penalty from getting to their money.
A deferred annuity also has negative consequences for estate planning. Generally, non-annuity assets inherited by the heirs are either going to be capital assets that are treated with a step up in basis at death and there are no taxes due or they are going to be assets that represent true gifts on which no income tax is due.
Receipt of a deferred annuity at death results in triggering a tax burden on the heirs that would create additional ordinary income taxable at the marginal tax rate for each heir. A child already in a high tax bracket and receiving an annuity at death, could end up being pushed into an even higher tax bracket.
IRAs are also a poor estate planning tool for the same reason as annuities. Unlike annuities, however, IRAs have special stretch rules that allow the taxation at inheritance to be less burdensome than the taxation of annuities.
There are two distinct phases of the annuity contract: the accumulation phase and the annuitization phase. During the accumulation phase, the owner generally is not taxed on the earnings credited to the cash value of the annuity contract unless a distribution is received. The accumulation phase continues until the annuity contract is terminated or the annuitization phase begins. The annuitization phase starts when the contract value is applied to an annuity payout option. This phase continues until the last payment is made according to the annuity payout period chosen by the owner (or in some cases, the beneficiary).
When an annuity contract is fully surrendered during the accumulation phase, the owner must pay income tax on the earnings in the contract. The owner is not taxed on amounts that represent a return of contributions (such as premiums or investment in the contract). Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis. In order words, withdrawals from an annuity are made earnings first, and the owner is taxed on the payments until all of the earnings have been distributed. There is an exception to the earnings first rule for contributions made to annuity contracts prior to 8/14/82. These contributions are distributed on a first in, first out (FIFO) basis and the owner is not taxed until such contributions are fully recovered.
There is an aggregation rule which requires that all annuity contracts issued by the same company, to the same owner, in the same calendar year must be treated as one annuity contract for purposes of determining the taxable portion of any distributions.
During annuitization - the income phase - a portion of each annuity payment represents a return of non-taxable investment in the contract and the balance of each payment is considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio. The exclusion ratio for a fixed annuity is the ratio the investment in the contract bears to the expected return under the contract. The ratio is determined by dividing the purchase price of the annuity by the sum of all payments.
The exclusion ratio for a variable annuity is determined by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered using the exclusion ratio, the annuity payments are fully taxable. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner in his last taxable year.
If an individual transfers ownership of a nonqualified annuity issued after 4/22/87, without full and adequate consideration, the owner must pay income tax on the earnings in the contract at the time of the transfer (except for transfers to a spouse or transfers made to a former spouse incident to a divorce). If the contract was issued before that date, the earnings in the contract can continue to be deferred, with the old cost basis carried over to the new owner. Transfer of ownership includes the addition or deletion of a joint owner. Also, the transfer of ownership may result in gift tax consequences for the owner.
Individuals who assign their annuities as collateral for loans may be surprised by the treatment of assignments. Generally, any collaterally assigned, pledged, or received as a loan under an annuity issued after 8/13/82 is treated as if it was distributed from the annuity. The amount collaterally assigned is taxed according to the rules applicable to partial withdrawals and full surrenders and may also be subject to the 10% penalty tax. If the entire contract is assigned or pledged, then earnings subsequently credited to the contract are automatically deemed subject to the assignment or pledge and are treated as additional partial withdrawals.
If the owner dies after the annuitization phase has begun, the remaining payments, if any, must be paid out at least as rapidly as under the annuity payout option in effect at the time of the owner's death. If a beneficiary receives the remaining payments under the annuity payout option in effect at the owner's death, the taxable and nontaxable portions of such payments will continue to be determined by the original exclusion ratio.
If the owner dies during the accumulation phase, the entire death benefit must be distributed within five years of the date of the owner's death. However, there is an exception to the five-year rule, if the death benefit is paid as an annuity over the life, or a period not longer than the life expectancy, of the beneficiary and the payments start within one year of the owner's date of death. If an annuity contract has joint owners, the distribution at death rules are applied upon the first death.
Under a special exception to the distribution at death rules, if the beneficiary is the surviving spouse of the owner, the annuity contract may be continued with the surviving spouse as the owner. If the owner of the annuity is a non-natural owner, then the annuitant's death triggers the distribution at death rules. In addition, the distribution at death rules are also triggered by a change in the annuitant on an annuity contract owned by a non-natural person.
Unlike death benefits paid from life insurance policies, the beneficiary may be taxed on distributions made from an annuity after the owner's death. Amounts paid under the five-year rule are taxed in the same manner as partial withdrawals or full surrenders, and amounts paid under an annuity option are taxed in the same manner as annuity payments. For variable annuity contracts issued on or after 10/29/79, and for all fixed annuity contracts, there is no "step-up" in basis for income tax purposes and the beneficiary pays income tax on the earnings. However, the beneficiary is entitled to deduct a portion of estate tax paid on the annuity for income tax purposes. For variable annuity contracts issued prior to 10/21/79, there is a "step-up" in basis for income tax purposes and no income tax is payable on the earnings.