Understanding the tax implications of annuities is key when planning for retirement. Annuities, and their tax benefits, are often misunderstood by clients but also by the financial advisers and insurance agents that market these products.
One of the principal benefits of an annuity is the ability to grow on a tax-deferred basis. However, an annuity is also subject to tax, and how it’s taxed depends on how it was funded.
Qualified vs non-qualified annuities
Annuities can be purchased either with qualified or non-qualified dollars. Qualified annuities are funded with pre-tax dollars, typically through an employer-sponsored retirement plan such as an IRA, 401(k) or pension plan. Contributions are tax-deferred, meaning taxes are paid when withdrawals are made.
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Non-qualified annuities are funded with after-tax dollars and only the interest portion of the withdrawal is taxable. However, depending on whether an annuity is immediate or deferred, it’s subject to either the exclusion ratio or last-in-first-out (LIFO) rules.
Exclusion ratio vs last-in-first-out
The exclusion ratio is used to determine what percentage of non-qualified annuity income is taxable and involves calculating the principal (non-taxable) and earnings component (taxable). After the principal has been depleted, any remaining income payments are considered to be interest. If the person lives longer than their actuarial life expectancy, any payments received after that age are fully taxable since the exclusion ratio is calculated to spread principal withdrawals over their lifetime.
For example, a $100,000 immediate annuity is purchased by a 65-year-old with 15 years of life expectancy (or 180 months) and the payment is $800 per month. About $555.56 of each payment is not taxable and the exclusion ratio is 69.4%.
LIFO tax rules dictate that earnings are always taxed first. Prior to the Tax Equity and Fiscal Responsibility Act of 1982, deferred annuities were subject to first-in-first-out (FIFO). Once the amount withdrawn exceeds the amount of earnings, subsequent withdrawal amounts are considered a tax-free return on the principal. After the original deposit has been reimbursed, all subsequent payments are completely taxable.
For example, a $100,000 fixed annuity grows to $150,000, meaning $50,000 is interest. If withdrawals begin after age 59½, all withdrawn funds up to $50,000 are subject to ordinary income tax. Amounts above $50,000 would be considered a return of principal and not subject to taxes. However, any proceeding withdrawals are once again taxed at ordinary rates.
Annuity inherited ‘stretch’
If a client inherits an annuity, the tax rules vary depending on which type was received. Inherited qualified annuities follow the SECURE Act, where the outcome depends on if the recipient is either an eligible or non-eligible designated beneficiary. If deemed eligible, the beneficiary can stretch payments over their life expectancy. If not eligible, the annuity would have to be withdrawn by the tenth year after the original account owner’s death. Withdrawals are subject to ordinary income tax, and it depends on whether the original annuity owner had begun taking required minimum distributions (RMDs) before passing away.
Inherited non-qualified annuities don’t benefit from a step-up in basis — meaning the taxes remain unchanged — but can be taken over a beneficiary’s lifetime. Beneficiaries who want to reduce their tax liability will use the stretch provision, which allows them to receive periodic payments of the annuity’s value over their life expectancy. As such, the remaining balance continues to grow tax-deferred, which helps the beneficiary reduce taxation.
1035 annuity exchanges
Existing non-qualified annuities can be exchanged — meaning no tax is paid on earnings — when moved from one insurance company to another. This process, known as a 1035 annuity exchange, is allowed under Section 1035 of the Internal Revenue Code. In addition, Section 844 of the Pension Protection Act of 2006 gave new incentives to fund long-term care with annuities and life insurance.
Clients with no need for their existing annuities can be effectively converted to a long-term care annuity, either partially or fully. Regardless of the reason, a 1035 annuity exchange offers a tax-free alternative to cashing in an unwanted annuity and using the proceeds to purchase a new one. This tax benefit can make a 1035 exchange a more attractive option for clients looking to optimize their annuity investments.
For example, a $100,000 fixed annuity grows to $150,000, meaning $50,000 is interest. A 1035 exchange transfers it to a long-term care annuity that provides benefits up to $450,000. If used for long-term care, the money used is completely tax-free.
Annuities are complex financial products that offer significant benefits, but the various tax implications require a deep understanding to navigate them effectively. It’s crucial to be informed and have competent guidance as part of an overall retirement planning strategy. By having a fundamental understanding, you can make more well-informed decisions for an enhanced financial outcome.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
