For many retirees, the income that is received from an annuity can provide either a nice supplement for additional travel and fun, or it may offer the funds that are needed for filling in an income gap for paying necessary living costs once an employer’s paycheck stops.
In any case, annuities have provided many retirees with a nice source of income during their retirement years. So, it is important to use these vehicles in planning for the future. Yet, in doing so, it is also essential to know how an annuity will be taxed so that you can make the most of the funds that you’ll have coming in.
What Determines How an Annuity’s Income Will Be Taxed?
When determining how an annuity’s income payout will be taxed, there are several key factors. One of the primary criteria will be whether the annuity was initially purchased with either qualified or non-qualified funds.
“Qualified” money is defined as earned income that is allowed to be contributed to a tax-deferred account under guidelines that are defined by the IRS (Internal Revenue Service). As an example, an employer-sponsored 401(k) retirement account is considered to be a qualified retirement plan.
After the income payouts from a deferred annuity have started, they will typically be taxed in the same manner that the distributions are taxed with all other tax-deferred qualified retirement accounts.
Therefore, regardless of whether the financial vehicle is an annuity, a CD, or a mutual fund, the income that will be received from the distribution will be taxed to the recipient at his or her ordinary income tax rate.
In many cases, however, especially with annuities, because the income is typically being received in retirement, the individual is often in a lower income tax bracket than they were in during their working years. Therefore, they can often receive a higher amount of net income than they would if they were receiving their income payout at an earlier time in their life.
A “non-qualified” annuity is an annuity that is funded with money on which taxes have already been paid. For example, these annuities will have been funded with money from a person’s checking or savings account as versus funds that were rolled over from a traditional IRA or a 401(k) plan.
With a non-qualified annuity, the income payout – as well as the amount of the income – will be based on the annuitant’s life expectancy. Here, a portion of the income payout will be considered as gain, and another portion of the income will be considered as a return of the annuity holder’s premium. The portion that is considered as gain will be taxed to the annuitant as ordinary income. The portion that is considered a return of premium will not be taxed. This is because taxes have already been paid on this money.
This tax treatment will differ from the sale of other non-qualified investments such as stocks, bonds, and mutual funds. With these types of investments, gains are typically taxed at an investor’s capital gains tax rate as versus ordinary income tax rates.
Understanding The Exclusion Ratio
The taxation of “annuitized” income will recognize that each of an annuity’s income payments will consist in part of the annuity’s holder’s original deposit, and in part of the gain, or earnings. With that in mind, the “annuitized” income will be taxed so as to exclude the original principal, and to tax the rest.
This is done through a process that is referred to as the exclusion ratio. This ratio will calculate the proportion of the annuity’s income that consists of the original deposit, and is therefore not taxable to the annuitant.
As an example, with an immediate annuity, the exclusion ratio will be the investment in the annuity contract divided by its expected return. The exclusion ratio will run out whenever all of the original deposited principal in the annuity has been received by the annuitant. This assumes that the annuity holder reaches that point and will still be receiving income from the contract.
It is also important to note that at that point, the entire amount of income will be considered as gain – and therefore, the entire amount of the income payout will then be considered taxable income to the annuitant.
With a variable annuity, the exclusion ratio will be calculated as the investment in the annuity divided by the number of anticipated income payments to the annuitant. The investment is the amount that the annuity owner deposited, less any withdrawals.
The number of anticipated income payments will be the number of years that the income payouts will be made, based upon the chosen income payout option – provided that the annuitant has chosen a set number of years. If, however, the life only option has been selected, the IRS life expectancy tables will instead be used to determine the anticipated length of the annuity’s income payout period.
In this case, the same exclusion ratio amount will be applied every year until all of the principal from the annuity has been paid out. The reason for using the exclusion ratio is so that the annuity holder’s original deposited funds can be paid out equally during the entire duration of the income payout period. If, however, the annuitant lives beyond that expected time frame, the income payments will consist 100% of gain – and will be taxed as such.
Additional Tax Advantages of Annuities
Annuities are also known for the additional tax advantages that are provided to their holders. This is primarily in the area of deferred annuities, as they offer tax deferral of the funds that are inside of the annuity’s account.
For example, a fixed deferred annuity – also often referred to as a tax-deferred fixed annuity – will have a fixed rate of interest credited annually by the offering insurance company. The growth, or gain, that occurs within the annuity account is allowed to continue without being taxed until the time the funds are withdrawn.
This deferral of taxes can allow the funds to grow and compound exponentially over time. This is because the money is compounding due to the initial interest, as well as due to the compounding on the funds that would have otherwise been taxed.
Because of this, tax-deferred growth may even provide the ability to outpace taxable investments because of the earnings compounding without the current income taxation, year after year. This type of tax treatment is not available on financial vehicles such as CDs or stocks that are taxable every year – regardless of whether their gains are withdrawn or not.
Variable annuities can be particularly appealing to those who are in a higher tax bracket and who are seeking more favorable ways of accumulating savings – especially if they are anticipating that their tax rate may fall once they reach retirement and are ready to access their annuity funds.
Some Items to Consider before Taking Funds from an Annuity
While there are many favorable tax-related avenues available concerning annuities, there is one that annuity holders need to consider before moving forward which may provide the least favorable tax treatment of all – and that is taking a lump sum withdrawal of the funds.
This is because, if the annuity holder opts to take a lump sum distribution, he or she will receive the entire value of the annuity’s contract – and in so doing, they will have tax liability for all of their earnings in one single year (this will occur in the year that the withdrawal takes place).
In addition to having this tax liability, the annuity holder will also, of course, lose out on the additional benefit of any continued tax-deferred growth on his or her funds within that annuity account once the funds have been withdrawn.
How and Where to Obtain the Best Annuity Rates in the Market Place
When shopping for the very best annuity rates in the marketplace, it is typically the wisest course of action to work with either a company or an agency that has access to more than just one annuity carrier. In doing so, you will be better able to directly compare, in an unbiased manner, multiple annuity carriers – as well as their features, benefits, and rates – and from there make a determination as to which one will be the best option for you and your specific needs.
If you are ready to move forward in making an annuity purchase – either for tax-deferred retirement savings or for more immediate, lifetime retirement income – we can help. We work with many of the top annuity carriers in the industry today, and we can assist you with obtaining all of the most important details that you will require for making an informed purchase decision.
We can do so for you quickly, easily, and conveniently – and all from your home computer with the touch of a few keystrokes. So, whenever you are ready to move forward, just simply take a moment to fill out the quote form on this page.
Should you find that you have any additional questions regarding how annuity income is taxed – or even if you have any questions about annuities in general – please feel free to contact us directly. Our experts are here to walk you through any concerns that may come up as you go through the process of better understanding annuity savings and income advantages.
Today, investors need additional sources of retirement income for the future. Corporations have all but stopped providing defined benefit pension plans – and no one knows what will happen with Social Security down the road. Couple that with the fact that our life expectancies are getting longer than ever before. While that can be great news – it also means that we absolutely must have ways of ensuring our ongoing income – and an annuity can be that key.
We are experts in the annuity income arena – so before you move forward into an unknown world of potential options, let us be your guide. We want to ensure that you have all of your questions answered about deposits, income, and taxes. So, contact us today – we’re here to help.