Annuities

Annuities are especially attractive to retirees because they assure an income for life. They’re often held as deferred annuities as a back up for those later retirement years as a supplement to other retirement income or when savings become depleted. But many retirees will die before tapping their deferred annuity. What are the tax consequences to the annuity beneficiary and should other options be arranged?

A deferred annuity offers a distinct tax-benefit. It’s earning grow tax-deferred. For the same annual return as a taxable investment, a tax-deferred investment compounds faster because none of the earnings are taxed away each year. However those tax-deferred earnings will eventually be taxed upon withdrawal, whether by you or the annuity beneficiary. Your contributions to the annuity, though, will not be taxed. This is the case in ‘nonqualified’ annuities which are funded with after tax contributions.

Annuitant’s taxation
If a partial withdrawal is made, the IRS presumes that earnings come out first – so that these are completely taxable. But under regular monthly payments – a portion of each payment is not taxed but treated as a return of your nontaxable contributions. An exclusion ratio calculated by the insurance company designates that untaxed portion. When, after some number of payments and you’ve received all your contributions, all future payments will be fully taxed as income.

Beneficiary taxation
After tax contributions made by the deceased owner will remain  untaxed when received by the beneficiary. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.

Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for the annuity beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments taxed at the deceased’s exclusion ratio.

If the annuity owner died before beginning annuitization, provision may be made for either a lump sum distribution or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.

But in the case of a series of guaranteed payments, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner’s contribution were fully received. Any payments beyond that would be fully taxed as ordinary income.

An annuity beneficiary, who earns a substantial income already, can lose a lot of that taxable portion of the annuity as he’s pushed into a high tax bracket. So, if annuity owner decides not to annuitize, he may use his annuity’s value to switch to another option better suited to his beneficiary.

Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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Fixed Immediate annuities can provide a steady income for a specified period of time that may even surpass your natural life. How long you choose to take these payments can depend on your present and future income needs, as well as your survivors’ requirements. But there is one more point that you may want to look at when reviewing the various payout options available, and that is the annuity tax implications to you and your beneficiaries.

A portion of the money you would receive each year is a tax-free return of your investment. The balance is taxable, and those amounts can vary among the different payment periods. For instance, suppose that you are a 65-year old male, the IRS gives you a life expectancy of 20 years, and you are offered the following choices for a $250,000 investment:

• A life only payout ceases when you die and will give you approximately $20,000 per year. Of this amount, $12,500 (1/20th of $250,000) would be tax-free and the balance ($7,500) taxable. If you live longer than 20 years, all $20,000 will be taxable.

• A life with 20-year certain pays for 20 years or your lifetime, whichever is longer. You would receive approximately $17,500 each year, $12,500 tax-free and $5,000 taxable. If you die before the 20 years has passed, your beneficiary will collect the remainder of the payments with the same annuity tax treatment as you had.

• A 10-year certain annuity will pay you approximately $28,500 per year for 10 years with $25,000 (1/10th of $250,000) tax-free and $3,500 taxable. If you die before the 10 years has passed, your beneficiary will receive the income for the balance of the term in a like manner.

The above numbers are strictly estimates and for illustrative purposes only. They do not imply any return on a specific investment, and do not include the impact of fees and charges on the growth or the payout. In addition, other payout options are available. However, they do show how your investment decisions could affect your annuity taxes.

For more information on investing with fixed immediate annuities, ask your retirement consultant.

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One popular benefit of a fixed annuity is that you can let the interest in the account compound each year without paying income taxes. This allows your money to possibly grow faster as compared to fully taxable investments that pay similar, before-tax returns. When you start making withdrawals, the percentage of income that is taxable depends on how you structure the distributions. Your beneficiaries, however, may not have that flexibility, and could face a big annuity tax bill on the inheritance.

Assuming your annuity is not held in a tax-qualified account, such as an IRA, your heirs will have to pay income tax on the built-up earnings when you die. Suppose that you put $250,000 into a fixed annuity a number of years ago, and now it is worth $450,000. If you died today, your beneficiaries would receive the $450,000, and would have to pay as much $70,000 in federal income taxes on the accumulated profit (maximum federal income tax rates are currently 35%).

To help your heirs keep the money you earned, you may want to consider purchasing a life insurance policy for the amount of the estimated tax bill. You could pay the premiums yourself, ask your beneficiaries to buy the policy to protect their future interests, or you could annuitize your annuity.

Annuitizing your annuity can give you a steady income that you cannot out-live. Part of the income will be a tax-free return of your original investment. The balance will be taxed as ordinary income. However, the $450,000 will no longer be available to go to your beneficiaries. To replace that money, you could use the regular income that you will receive from the annuity to help pay life insurance premiums on a $450,000 policy. After you die, your loved ones will receive the entire $450,000, free of federal income taxes.
Not everyone can qualify for a life insurance policy. Depending on the payout from the annuity, your health and other factors, the payout from the annuity may not cover the full premium payment on the life insurance. For more information about annuitization or annuities get a copy of Annuity Owner Mistakes.

Annuity taxation can be onerous or painless depending on your planning and getting qualified advice.

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