Annuity Tax Advantages
Important: Consult your tax professional for complete information regarding annuity taxation. The tax laws vary from one type of annuity to another.
A qualified annuity is taxed identically to any other qualified account, such as an IRA, 401(k), profit-sharing plan, or other tax-deferred retirement account.
A nonqualified annuity is taxed differently from most investments:
- It grows tax-deferred until withdrawals begin or until the policy is annuitized.
- It does not provide a step-up in cost basis at death, and the deferred earnings are taxable as ordinary income to a nonspousal beneficiary.
- Spousal continuation of the policy may be available to preserve continued tax-deferred growth of the annuity.
- An annuity is included in your estate for estate tax purposes.
Withdrawals From an Annuity
Withdrawals of earnings from a nonqualified annuity are fully taxable at ordinary income tax rates. This includes annuity income riders. Unless the annuity was purchased before August 14, 1982, the earnings are considered withdrawn first and are therefore subject to taxation. All withdrawals are fully taxable as ordinary income until the account value reaches the initial amount invested in the annuity.
Because annuity income is taxable at ordinary income tax rates, you do not receive the benefit of lower capital gains tax rates. Also, if you are under age 59 ½ when you make the withdrawal from the annuity, you may be assessed a 10% penalty on any taxable earnings.
Annuitized Payments From an Annuity
If you annuitize a nonqualified annuity, a portion of your payment is considered a return of premium and is not subject to ordinary income tax. The amount that is taxable is determined at the time you elect to annuitize the policy. The insurance company calculates the "exclusion ratio," which determines the percentage of each payment to be excluded from income tax.
Taxation at Death - Spousal Continuation for an Annuity
Many variable annuities enable your spouse to continue the policy at your death. Some companies pay the death benefit into the policy and continue the original policy without tax consequences. Others require your spouse to choose either the death benefit (if the account value is lower than the death benefit) or spousal continuation.
Choosing the death benefit in these situations is a taxable event; your spouse is taxed at ordinary income tax rates on the difference between the death benefit and the amount you invested, adjusted for any withdrawals. In most cases, the annuity policy is not included in your taxable estate for estate tax purposes due to the marital allowance. Consult the annuity prospectus for the terms of spousal continuation.
Taxation at Death - Non-Spousal Beneficiary for an Annuity
At your death, the death benefit is paid to the non-spousal beneficiaries you have designated in the annuity contract. This keeps the annuity transfer out of probate. Unlike most other securities, there is no step-up in cost basis at your death. Instead, any deferred income in the policy is taxable to the beneficiaries as ordinary income at their tax rates.
If a death benefit is paid out that is higher than the account value of the annuity, the difference between the death benefit and the amount you invested in the annuity, adjusted for any withdrawals, is taxable as ordinary income to the beneficiaries. The value of the variable annuity policy also is included in your estate for estate tax purposes. Beneficiaries have the choice of taking a lump-sum payment or receiving the payments over time from the annuity, thereby spreading out the income tax liability.
