How does the government tax an annuity?

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One of the main advantages of annuities is that they can grow while deferring taxes. But that doesn’t mean policyholders can ignore Uncle Sam forever. And how these vehicles are ultimately taxed is often complex and poorly understood.

Eligible and non-eligible annuities
In general, annuity owners pay no tax until they have withdrawn their money (unless the owner is a corporation or trust; non-human owners must pay taxes on the growth of the annuity. every year). Yet the amount of tax owed depends on a number of factors.

One of them is the way the annuity is held. If you bought it with pre-tax dollars – as part of an IRA, 403 (b), or tax-advantaged retirement account, for example – it is considered a “qualified” account and payments are fully taxable as ordinary income. On the other hand, if you purchased the annuity with after-tax dollars, and not as part of a retirement account, it is considered “ineligible” and only the net gain (earnings or growth). is taxable, not the money you originally invested. (also known as cost base).

“Income from an ineligible annuity will be partly taxable and partly non-taxable, based on cost,” says Michael J. Zmistowski, personal financial planner in Tampa, Florida.

The ordinary tax rate applies whether it is a variable or fixed annuity. But calculating how much of each ineligible annuity payment counts as a net taxable gain and how much under the tax-free cost basis can be tricky.

“Unqualified annuities with income riders are taxed using the last in, first out (LIFO) method,” says Joanne Lam, senior vice president of wealth management at Freedom Capital Management in Holmdel, NJ. “All income from the income rider is distributed first and is subject to ordinary income tax. Once the gains are fully withdrawn, the remainder of the distributions are from the original capital and are not subject to tax.

That is, distributions that exceed the net benefit of the annuity are considered a return of the cost base and are therefore tax free.

The exclusion rate
If, however, the distribution of an ineligible annuity does not come from an income rider but rather from a partial annuity of the contract, the taxable portion of the payment is subject to a somewhat more complex formula. Such contracts “follow a different calculation to determine the taxable portion of the income stream,” says Todd Giesing, assistant vice president and director of annuity research at the Secure Retirement Institute in Windsor, Connecticut. “It’s called the exclusion ratio, and it calculates a portion of the income paid that would be earnings under the assumption of predetermined mortality. “

In other words, the exclusion ratio is based on the expected return of the contract, itself based on the life expectancy and age of the annuitant at the time of purchase of the contract. Annuitants can calculate the ratio as the base cost divided by the expected number of years they have left when purchasing the annuity (according to the insurer’s mortality tables). So someone who buys an annuity at age 85 may have largely tax-free payments, whereas “if you get a quote for someone younger, say 50, more of the payment would be taxed.” explains David Blanchett, Managing Director and Head of Retirement Research at QMA, a specialist in quantitative equity and multi-asset solutions.

Tim Rembowski, vice president of membership success at DPL Financial Partners in Louisville, Ky., Says, as an example: “If you had [an annuity with a $100,000 cost basis] and you have 20 years left on the actuarial table, then $ 5,000 of each payment would be tax free. Anything over $ 5,000 would be taxed as income.

The exclusion ratio also takes into account the income option you choose, whether it is lifetime payments, payments for a specified number of years, or joint payments in which a surviving spouse receives the benefits. after the death of the account holder. “All of this,” says Michael Harris, senior education advisor at the Washington-based Alliance for Lifetime Income, “helps determine your monthly income check. The insurance company will provide a 1099 at the end of the year with all associated tax information.

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