Annuities are valuable tools, when used correctly. No other financial product on the market can provide the kinds of guarantees on income that an annuity does. But it's vital to understand the tax treatment of annuities as well.
Here are some of the most important aspects:
Qualified vs. non-qualified annuities
Broadly, annuities can be divided into two categories: qualified and non-qualified. Generally, any annuities you buy in a traditional IRA or within a tax-deferred retirement plan are tax-qualified. All other annuities - including annuities you own in your own name, outside of a retirement account - are non-qualified
All annuities enjoy the benefit of tax deferral on current income and any growth in the value of the contract. As long as the assets remain in an annuity and you don't cancel the contract, taxes on income and capital gains earned within the annuity are deferred until you either surrender the contract or you begin taking income.
1035 exchanges - All annuities also qualify for tax-free exchanges under IRC Section 1035. That is, you can switch assets from a life insurance to an annuity, or from annuity to annuity, without incurring a tax liability. This is an advantage over stocks, bonds and mutual funds in taxable accounts, which generate potential taxes on capital gains when you sell them at a profit.
Early withdrawals - Annuities are generally subject to a 10% penalty on withdrawals before the beneficiary reaches age 59½.
Annuity taxation in retirement
Qualified annuities - All income paid out by a qualified annuity is taxable as current income. This is because you didn't pay income taxes on money you contributed as premium. Instead, you pay taxes as you withdraw it as income.
Non-qualified annuities - Earnings from non-qualified annuities are returned to you tax-free over your remaining life expectancy. Only the earnings are taxed. So, part of your income each year is taxable, and part will be non-taxable return of premium. The percentage of your income that is not taxed is known as your "exclusion ratio."
Once you reach your life expectancy, you will have recouped your investment in the annuity. Income after that point is taxable.
Spousal beneficiaries - If a spouse inherits an annuity, he or she can generally keep taking income according to annuity contract terms. It does not create a taxable event.
Non-spousal beneficiaries - When someone other than a spouse inherits an annuity, he or she will owe taxes on earnings, but not on contributed premiums.
Non-spousal heirs can generally choose from these options:
- Cash out the annuity at once.
- Leave part or all of the annuity value in place for up to five years.
- Convert the annuity to an income stream either over their life expectancy or for a specific period of time.
The latter two options have the benefit of greater tax deferral, and of spreading the tax liability over a greater number of years.
If the heir doesn't like an inherited annuity, they can execute a tax-free 1035 exchange to another annuity with different features, guarantees and fee structures. However, there may be surrender charges and other fees to take into account.
Estate tax issues
Annuities are considered assets within the original annuity owner's estate, and therefore may be subject to estate taxes. Unlike many other securities, non-qualified annuities don't provide a stepped-up basis at death.
Deferred income within the annuity is taxable as ordinary income to beneficiaries.
Please contact us if you would like to discuss in more detail.