The taxation of annuities depends on two criteria: First, whether the annuity is purchased with qualified or non-qualified money, and second, whether the annuity is deferred or immediate. Qualified money is almost always used to purchase a deferred annuity. Non-qualified money is more likely to be used to purchase an immediate annuity, but can be used to buy a deferred annuity. While the following will provide information about the taxation of annuities, it is only intended to give a general overview. An annuity investor is always advised to consult with a tax professional or financial planner prior to purchasing or selling an annuity in order to fully understand the federal and state tax implications specific to his or her own unique financial situation.
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What is Qualified Money?
Qualified money is earned income that can be contributed to a tax-deferred account under guidelines defined by the Internal Revenue Service. An individual retirement account (IRA), a simplified employee pension (SEP) or an employer sponsored defined contribution plan such as a 401(k) are among the various types of qualified retirement accounts.
Tax-deferred, which should not be confused with tax-exempt, means that both the principal contributed to the annuity and all compounded earnings accumulate for a number of years without being taxed until the money is distributed. Distribution of the principal and the earnings, along with taxes, are deferred until a later point in time, most often at retirement.
Once the distributions of a tax-deferred annuity begin, they are taxed in exactly the same way distributions from all other tax-deferred qualified accounts are taxed. Whether the investment was an annuity, a mutual fund, certificate of deposit, stocks or bonds, the income received from the distribution is taxed at ordinary personal income rates based on the yearly income of the annuitant. The advantage of a tax-deferred annuity is that in most cases, the annuitant is in a lower tax bracket after retirement than he or she was before retirement.
What is Non-Qualified Money?
Non-qualified money is money on which taxes have already been paid. Also known as “after tax” or “post tax” dollars, non-qualified money is primarily kept in checking, money market, and savings accounts. After tax dollars can also remain after taxes have been paid on the proceeds from the sale of stocks, bonds or mutual funds, an inheritance, or the sale of a business.
The taxation of a non-qualified variable annuity is unlike all other investments. Like a qualified deferred annuity, a non-qualified variable annuity grows tax-deferred until the annuitant begins taking distributions. However, the Internal Revenue Service considers a portion of the distribution to be a return of capital. That is, the issuer of the annuity is simply returning to the annuitant money he or she contributed, so only the interest credited, if any, is taxed.
With a non-qualified immediate annuity, the distribution and the amount of the distribution that is taxed are based on the life expectancy of the annuitant. For example, if the annuity contract states that annual payments on a $200,000 immediate fixed annuity would be $16,000, and the IRS deems the life expectancy of the annuitant to be 20 years after payments begin, $10,000 each year would be distributed tax-free
and $6,000 would be taxed at ordinary income tax rates.
Gains are taxed at ordinary income rates, not at capital gains rates. This differs from the sale of other non-qualified investments such as stocks, bonds, mutual funds, and real estate. The gains from the sale of these investments are taxed at capital gains rates, not ordinary income rates. If the annuitant lives beyond his or her life expectancy, then all subsequent distributions are 100% taxable.
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The Taxation of an Inherited Annuity
Immediate annuities can be either single or joint, meaning that they can be purchased by one person individually or by a married couple jointly. In the case of the death of the owner of a variable annuity, some contracts allow a surviving spouse to continue the policy without any tax consequences. Some annuity issuers will pay the death benefit to the policy, thereby avoiding a tax event for the spouse. However, a spouse who chooses to receive the death benefit does trigger a taxable event. The difference between the amount invested and the death benefit is then taxed at ordinary income rates. It is again important to point out the gains on annuities are taxed as ordinary income, not at the lower, more favorable capital gains rate.
Unlike all other investments, from mutual funds, certificates of deposit, stocks and bonds to real estate, that are passed from a decedent to a non-spousal beneficiary, deferred annuities do not qualify for the “step-up basis” rule under federal tax law. The step-up basis rule allows a beneficiary to claim an inherited asset at its current fair market value rather than at the decedent’s original purchase price. This effectively minimizes the capital gains tax liability that will be owed by the beneficiary when he or she sells the asset.
For example, if a beneficiary inherits stock at $20 per share for which the decedent paid $5 per share, and then sells the stock at $25 per share, he or she is able to claim the basis cost of the stock as $20, not $5. Therefore, capital gains taxes paid will be due on the difference between $20 and $25, not $5 and $25. Further, any deferred income from an annuity received by the beneficiary will be taxed at ordinary income rates. A non-spousal beneficiary, then, is often advised to take annual payments as opposed to a lump sum distribution in order to spread the tax liability over a number of years.
The taxation of annuities can be quite complex and can depend on additional factors specific to the circumstances of each individual investor. It is therefore recommended that all annuity investors obtain a copy of Internal Revenue Service publication 939, General Rule for Pensions and Annuities. It can be downloaded at the IRS website at http://www.irs.gov.
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