Taxation of Annuities: FAQs
From: Whitepaper | Authored By: Heather L. Schreiber, RICP®
Annuities come in various shapes and sizes: non-qualified, qualified, variable, fixed, index, deferred, immediate—you get the idea. In my role as an advanced planning consultant, I find that financial professionals may struggle with the tax complexities associated with annuities, mainly when dealing with an already tax-deferred source of funds, such as qualified monies or when a non-natural owner is considered.
This month’s Advanced Markets, Explained white paper will focus on the most frequently asked tax questions that I receive from financial professionals.
Note: Encourage your clients to work with their tax professional to ensure that the strategies discussed are right for them and align with any broader tax strategy. The goal is to maximize taxefficient retirement income.
What is the difference between a deferred annuity and an immediate annuity?
A deferred annuity (DA) is a contract with an insurance company that promises to pay income in exchange for ongoing contributions or a lump sum contribution at a future date. In contrast, an immediate annuity (IA) is purchased with a single lump sum in exchange for payments that begin
within one year of purchase.
Are DAs and IAs taxed the same way?
Generally speaking, no. DAs are typically taxed on a last-in, first-out basis (LIFO), meaning withdrawals first come from taxable earnings. Once earnings are depleted (on a non-qualified contract), the basis, or initial premiums paid to fund the contract, are returned tax-free. Any taxable portion of a withdrawal is taxed as ordinary income.
Note: Cost basis established before August 14, 1982, referred to as pre-TEFRA basis, comes out on a first-in-first-out basis (FIFO). Policies that contain a pre-TEFRA basis must separately account for this grandfathered basis to get the more favorable FIFO tax treatment on that portion of the basis.
If the DA is qualified, meaning it’s an IRA, for example, withdrawals are fully taxable unless there is a basis in the policy from after-tax contributions (or non-deductible contributions). If an IRA also has after-tax contributions, any subsequent withdrawals will be taxed on a prorata basis; a percentage of each withdrawal will be a return of basis and pretax monies. Keep in mind, all IRAs are combined when determining how much of the withdrawal will be taxable when there are after-tax contributions in any IRAs owned by the same owner.
Non-qualified immediate annuities, on the other hand, are taxed on a preferred basis, known as exclusion ratio treatment. The exclusion ratio refers to the portion of each immediate annuity payment that is not subject to taxes. Unlike a withdrawal from a deferred annuity that is taxed LIFO, each immediate annuity payment is calculated such that the percentage the cost basis bears to the number of payments is tax-free.
