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.
This first part of this chapter will focus on the tax treatment of so-called non-qualified annuities, that is annuities purchased with after-tax dollars. Qualified annuities -- annuities purchased in qualified retirement plans and IRAs — are subject to an entirely different set of tax rules. Qualified contracts are explored at the end of this chapter. It is critical to make this distinction between qualified and non-qualified annuities. Non-qualified annuities represent the investment of after-tax dollars, which grows in a tax-deferred setting. Monies eventually received from a non-qualified annuity will be treated as either tax-free return of principal and taxable growth or earnings. 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.
As we learned in Chapter 1, there are two distinct periods in an annuity contract: the accumulation phase and the annuity phase. In the accumulation phase, the contractholder retains control over the contract's cash value and may choose to surrender the contract, make a partial withdrawal, exchange the contract for another annuity, and in the case of variable annuities, redirect the investments from one subaccount to another. The contractholder may also choose to annuitize the contract. Once the contract enters the annuity phase, however, the contractholder loses control. The contract is converted into a vehicle that simply will distribute annuity payments using the payout method selected by the contractholder. All immediate annuities pay only annuity payments (there is no accumulation period). Deferred annuities allow for both withdrawals prior annuitization and annuity payments, if the contractholder chooses to annuitize the account. The tax code recognizes these two periods — and different tax treatments apply to monies taken from the contract during the accumulation period versus annuity payments received during the annuity phase. The tax code refers to the latter payments as "amounts received as an annuity" -- while monies taken out during the accumulation phase are cleverly referred to as "amounts not received as an annuity".
Income Tax Treatment During the Owner's Lifetime
It is important to note that regardless of who receives the funds, the contractholder will be taxed if the monies are disbursed from the contract while the contractholder is alive. In the great majority of cases, the contractholder will be the person receiving the funds — either through lifetime withdrawals or annuity payments. But in situations where the monies are paid to a third party, the contractholder will be taxed nonetheless. For example, a father buys an immediate annuity and directs the annuity payments to be paid to his daughter. The IRS will tax the father for the payments received by the daughter.
Amounts Received as an Annuity
Under the tax code, an annuity is a series of payments that include the liquidation of the principal sum. Lifetime annuities, as well as annuities for a fixed period, meet this definition (as would winnings of a lottery paid over time, or a structured settlement of a law suit). The basic premise of the tax code is that each periodic annuity payment is part interest and part return of principal. The interest or earnings portion of each payment is taxable as "ordinary income", while the portion representing the return of principal is tax-free (in tax talk, it is "excluded from tax").
In order to determine which portion of each annuity payment is taxable — or more correctly stated, which portion of the payment is tax-free — the IRS has established an "exclusion ratio". This ratio is calculated differently depending on whether the annuity is a fixed or variable contract. In the case of fixed annuities, the exclusion ratio compares the total investment in the contract with the expected return. The total investment equals any premiums paid by the contractholder to the annuity company, less any withdrawals or dividends received by the contractholder. The total investment is adjusted if the payout method includes any refund features, such as "lifetime with 10 year period certain", or "joint life with one-half survivor". If the payout method contains protection for a beneficiary, the total investment will be adjusted (reduced). The expected return is based on the annuitant's remaining life expectancy (survivorship factor). While each company may base its payout schedules on its own survivorship factors, the IRS requires taxpayers to calculate the exclusion ratio using IRS life expectancy tables.
As a simple example, Harry Johnson invested $158,400 in an immediate, straight life, fixed annuity in November 2007 that will pay him $1,250 per month ($15,000 per year). Harry is 68 years old. According to the IRS life expectancy tables, Harry is projected to live another 17.6 years and collect a total of $264,000 (17.6 x $15,000). His initial investment represents 60% of his total return. ($158,400 / $264,000 = 0.60 or 60%). Put another way, 60% of the checks he will receive represent return of his investment, which is excluded from taxation. Harry's exclusion ratio is 60%. Each year Harry will receive annuity payments of $15,000. Of this, 60% is tax-free ($9,000) and the remaining 40% ($6,000) is taxable each year as ordinary income. At the end of 17.6 years, Harry will have received back his entire investment (17.6 x $9,000 = $158,400).
What if Harry lives longer than the 17.6 years the IRS assumed he'd live? Prior to 1987, the tax rules stated that Harry could continue to apply the exclusion ratio, even though he had already recouped his entire investment. Those rules remain in effect if the annuity payments started prior to January 1, 1987. If the annuity period started after that date, new rules apply. More recent contracts may apply the exclusion ratio only until the entire principal is returned (that is, up to the projected life expectancy); thereafter, the exclusion ratio no longer applies and the entire annuity payment is taxable.
Keep in mind that this was a very simple example. Harry selected a straight life annuity payout, so there was no refund feature to adjust for. The annuity payments started immediately, so there was no chance for Harry to make a withdrawal, which would also call for adjustments. The IRS has a number of life expectancy tables — some are gender specific, others are unisex. Adjustments are made to the tables if the annuity payments are paid quarterly or annually, instead of monthly. Different tables apply depending on whether the investor added funds to the contract after June 30, 1986. Needless to say, calculating the proper amount of the annuity payment to include on one's tax return can be complicated — and may fall outside the realm of most advisors' expertise. Financial advisors should, however, be aware of the basic premise of an exclusion ratio and have a rough idea of how it is calculated.
In the case of variable annuities, the expected return from the contract cannot be accurately measured — it is, after all, based on the varying future value of a fixed number of annuity units. What can be projected accurately is the annuitant's remaining life expectancy. Taxpayers who own variable annuities calculate their annual exclusion factor by dividing the total investment in the contract by the life expectancy found in the IRS tables. Just as with the fixed annuities, this represents a return of principal spread evenly over the expected remaining life of the annuitant.
Assume in the previous example Harry had invested $158,400 in an immediate variable annuity. He choose a straight life payout at age 68, when the IRS assumes he has 17.6 years to live. Each year Harry would receive the first $9,000 tax-free each year ($158,400 / 17.6 years = $9,000). Any annual variable annuity payments Harry receives in excess of this amount will be taxable.
Please note that the $9,000 equals the tax-free amount he’d receive annually under the fixed annuity exclusion ratio above. This is no coincidence — the calculations are based on the same investment and life expectancy. What is different is that Harry won’t know how much taxable income he’ll receive each year — that is based on the investment performance of his separate account.
It is possible that in some years the investment results of the separate account may not generate enough to pay out the exclusion amount. In which case, the entire annuity payment will be received tax-free. If the annuitant lives as long as the projected life expectancy, he or she will have received back all of their investment. Depending on when the variable annuity payments started, future payments may or may not be excluded from taxation (using the same rules and dates that applied to fixed annuities above). While calculated differently, the exclusion ratio on a variable annuity performs the same function as it does for fixed annuities — it is a way to account for the tax-free return of principal in a series of periodic payments.