Taxation of Annuities
Qualified Annuity Plans
A qualified plan is a tax-deferred arrangement established by an employer to provide retirement benefits for employees. It “qualifies” for special tax treatment if it complies with various government requirements known as the Employee Retirement Income Security Act (ERISA). A qualified annuity is an annuity purchased as part of a tax-qualified employer-sponsored retirement plan – or individuals can purchase qualified annuities within their Individual Retirement Accounts (IRA).
Simply put, monies that are contributed by employers or employees to qualified retirement plans are tax deductible, and earnings grow in the plan tax-deferred. This allows for more rapid growth in the plan. When monies are disbursed to retired employees, the full amount of the pension benefit is subject to tax as ordinary income — there is no exclusion ratio. Withdrawals prior to retirement might be possible under certain circumstances, depending on the plan's language. Withdrawals from qualified plans are also fully taxed as ordinary income — there is no LIFO or FIFO accounting. Withdrawals from qualified retirement plans prior to age 59½ are also subject to a 10% penalty. This penalty is waived in the event of death, disability, or if the payouts are structured as a series of payments to be paid over the participant's lifetime. This 10% penalty is similar to the penalty for premature withdrawals from a deferred annuity discussed above (although it is important to note that the penalty in the case of deferred annuities applies to only the earnings portion of the withdrawal. In the case of qualified retirement plans, the 10% penalty applies to the entire withdrawal — since the entire withdrawal is taxable.) The IRS also requires retirees to begin to take distributions from qualified plans (and traditional IRAs) at age 70½ — or face a 50% penalty. There is no such requirement or penalty for nonqualified (“regular”) annuities.
A full discussion of the various types of qualified plans is beyond the scope of this program. Generally speaking benefits paid from qualified retirement accounts are fully taxable as ordinary income (because the contributions were made in pre-tax dollars and the earnings grew tax-deferred). There are a couple of exceptions worth noting. Some contributions to IRAs are not tax deductible, that is, the contributions are made in after-tax dollars. For those contributing after-tax dollars to their IRAs, a portion of the eventual withdrawals will be tax-free return of principal (using a variation on the exclusion ratio). Roth IRAs and Roth 401k plans operate on a different premise than other qualified plans: after-tax dollars are contributed, the account grows tax-deferred, and if the participant keeps the contribution in the account for at least five years, withdrawals (taken after age 59½) will be tax-free. If taken before age 59½ or before the funds have been in the account for five years, the earnings will be taxable as ordinary income (principal is returned tax-free). Premature withdrawals from Roth accounts are taxed on a FIFO basis (return of tax-free principal first, then taxable earnings), but there is no 10% penalty.
As we’ll see in Chapter 3, many employers commonly use annuities to pay their pension benefits. Many companies with defined benefit plans purchase annuities as a way to fund the pension plan and distribute pension benefits. These defined benefit plans are called "annuity purchase plans" for this reason. In contrast, companies with defined contribution plans usually invest the plan’s assets outside of an annuity, but rely on annuity contracts to provide employees with a guaranteed lifetime payout.
A Tax Sheltered Annuity, or TSA, is a special type of annuity plan reserved for employees of educational and nonprofit organizations. These plans are also called "403(b) plans" or a "501(c)(3) plans," after the sections of the Tax Code that make them possible. Through these sections of the tax code, the federal government has encouraged specified nonprofit charitable, educational and religious organizations to set aside funds for their employees' retirement. Funds set aside in a TSA are not included in the employee’s current taxable income. In other words, all contributions to a TSA are made with “before-tax dollars”. This is true whether employers contribute funds on behalf of their employees or the employee contributed funds through a reduction in salary. These ongoing contributions are paid into a deferred annuity (fixed, variable or indexed). Like all annuities, earnings in the annuity grow tax-deferred.
Most TSAs are primarily funded by an employee's contributions through a salary reduction agreement with an employer. A fixed amount of money is deducted from each paycheck before taxes are taken out. The TSA contributions then grow on a tax-deferred basis. The maximum amount that can be contributed to a TSA each year is the same as for 401k contributions -- and this amount is adjusted periodically for inflation. In 2009, a TSA participant can elect to contribute a maximum of $16,500 ($15,500 in 2007 and 2008). For older employees (age 50 and above), additional "catch-up" contributions are allowed ($5,500 in 2009, $5,000 in 2008 and 2007). A TSA may also be partially funded by contributions from the employer. The employer may make matching contributions or contribute a fixed percentage of an employee's compensation to the TSA — again, subject to limits similar to 401k plans.
Upon retirement, the tax-sheltered annuity can be annuitized to provide retirement benefits. All payments received by employees from the accumulated savings in tax -sheltered annuities are taxable income (there is no exclusion ratio, since the contributions were made with before-tax dollars and earnings grow tax-deferred). When employees retire they usually find themselves in a lower tax bracket, so retirement income payments from the TSA are likely to be taxed at a lower rate than the income that was sheltered during their working years.
In summary, annuities can be used in a qualified retirement account for a couple of different purposes — deferred annuities in their accumulation phase provide an investment vehicle during an employee's working years, and upon retirement immediate annuities can provide a means to distribute lifetime pension benefits. In fact, the federal law governing pension plans requires payouts to married retirees to be in the form of a joint and survivor annuity (unless waived in writing by the spouse). This protects a surviving spouse in the event the employee dies.
As we'll see in the next chapter, many (larger) employers use group annuities to cover their workforce. Individual annuities are better suited for Individual Retirement Accounts, or for employers who wish to cover a few employees.