Tax Treatment of Annuities
One feature many annuity salespersons extol is the tax-deferred nature of an annuity. While it is true that annuities offer some distinct tax advantages, it is also true that they contain tax pitfalls for the unwary. The tax code regarding annuities is very complicated and, in many instances, not entirely clear. Many factors affect the ultimate outcome of an investment in annuities: ownership, beneficiary designations, distributions requirements, etc. It is easy for an advisor to make mistakes that could have serious consequences for both the client and advisor. Therefore it is very important that financial advisors be aware of the tax regulations, if for no other reason than to be aware of the limitations of their own understanding — and refer clients to expert tax advice when conditions warrant a referral.
For a detailed discussion of annuity tax treatment click here. The following summarizes the tax treatment of non-qualified annuities held by individual taxpayers:
During the Contractholder's Lifetime:
All earnings in the account are tax-deferred. As long as the earnings remain with the annuity company, there is no tax consequence to the contractholder. (This tax-deferral is not available to all investors -- corporations, and some trusts, do not enjoy tax-deferred growth.) Taxes on that growth will be owed when the annuity company pays it out to the contractholder or beneficiary. Regardless of the source of that growth (interest in the case of fixed annuities, stock market gains in the case of variable contract), the growth portion of the contract will always be taxed as ordinary income, never as capital gains.
If the contract is annuitized, each periodic annuity payment is considered to be partial return of principal, which is tax-free, and partial return of earnings, which are taxable. The tax-free portion (or portion "excluded from tax") is based on an "exclusion ratio". For fixed annuities, that ratio compares the total investment in the contract with the total expected payments to be received by the annuitant (based on IRS life expectancy tables). For variable annuities, the annual exclusion ratio is simply the total investment in the contract divided by the annuitant's life expectancy. All taxes are the responsibility of the contractholder, regardless of who receives the periodic payments.
During the accumulation phase, the contractholder can surrender the contract, withdraw a portion of the contract's value or exchange the contract for another.
¨ surrender: all value in excess of the contractholder's investment (cost basis) is taxable as ordinary income
¨ partial withdrawal: the withdrawal may be taxable earnings or tax-free return of principal depending on how much is withdrawn and when the contract was established. For recently purchased contracts, a partial withdrawal is treated as earnings first, and then return of principal. (so-called LIFO accounting) For contract established before August 12, 1982, amounts withdrawn are treated as tax-free return of principal first, then taxable earnings (FIFO accounting).
¨ exchanges: under Section 1035 of the tax code, a contractholder may exchange an annuity for another annuity free of tax consequences. (Section 1035 also permits a tax-free exchange of life insurance policy for another policy, or an exchange of a life insurance policy for an annuity contract. Section 1035 does not permit tax-free exchanges of annuities for life insurance.) There are many reasons to exchange annuity contracts: to switch from a fixed to a variable contract, or vice versa; to upgrade to a higher-quality annuity company; to consolidate multiple annuities into one contract; to obtain less-restrictive contract terms; to obtain a contract with more favorable annuity payout factors or contract guarantees; etc.
Upon the Contractholder's Death
If the contractholder annuitized the contract, any payments to the beneficiary must continue to be paid out at least as quickly as the annuitant was receiving (i.e., the beneficiary may not slow down the payments). The beneficiary is responsible for any income taxes owed on the payout.
If the contract was in the accumulation phase at the time of contractholder's death, the beneficiary must pay taxes on the taxable portion of the death benefits (the contractholder's cost basis in the contract is received tax-free using FIFO accounting). This is unlike life insurance death benefits, which the beneficiary receives entirely income tax free. As a general rule the beneficiary must take the accumulated value from the account no later than 5 years after the date of death. There are some exceptions to this general rule and advisors should note this is a very complicated part of the tax code.
For estate tax purposes, the value of the contract must be included in the decedent's estate tax calculation. If still in the accumulation period, the value of any death benefits are included in the taxable estate. If in the annuity period, the value of any remaining payments to beneficiaries must be included in the taxable estate.