It’s not surprising that annuities are rising in popularity. In this era of low returns, economic uncertainty and volatile markets, guaranteed lifetime income is very attractive. One downside to annuities is that distributions are taxed as ordinary income.
When you know the tax law, however, this annuity disadvantage isn’t so bad. A big chunk of your annuity income can be tax-free. Know the rules and you can maximize the tax-free portion of each annuity payment.
Let’s look first at the opportunity in select, but important, cases to have your annuity distributions be completely tax-free. Not many people know this, but it can provide a real benefit to people who need long-term care (LTC).
Typically, when distributions are taken from a deferred annuity, the income and gains are included in gross income and taxed as ordinary income. There’s an exception for distributions that are taken to pay for long-term care. Those distributions are tax-free. To qualify, the annuity owner must need assistance with at least two of the activities of daily living (eating, dressing, bathing, walking, etc.), and a medical professional must certify that need.
Not all annuities qualify for this treatment. The annuity must contain language mandated by the 2006 tax law. So if your annuity predates the law, distributions probably won’t be tax-free; and even many annuities issued after then don’t qualify. In fact, insurance experts tell me only a handful of annuities meet the rigorous LTC qualifications. You need to check with your insurer or insurance agent to determine if an annuity qualifies.
When your annuity doesn’t qualify, you can use a section 1035 exchange to trade the old annuity for a new one with the right language, and the exchange will be tax free. There might be surrender penalties for exchanging the old annuity and a commission for purchasing the new annuity. Check all the costs and consequences before deciding if this move is worthwhile.
Many annuities are used at least partially to pay for long-term care expenses. If you own a deferred annuity or are thinking of buying one, consider the potential of tax-free distribution as part of your plan to help pay long-term care expenses.
Now, let’s turn to regular income distributions from annuities. We’re considering here what are known as commercial or nonqualified annuities. Annuities from your qualified retirement plan might have different tax rules. The rules are the same whether you have a variable annuity, deferred annuity or immediate annuity.
Most income distributions are made periodically on a schedule, either monthly or less frequently. Commercial annuities generally are those sold by insurance companies outside of qualified retirement plans.
Commercial annuities that have been annuitized are taxed under what is called the General Rule. "Annuitized" means you have elected to take a series of regular payments that last for longer than one year. The most common election is for the payments to be received monthly and paid for your life or the joint life of you and your spouse, known as a joint and survivor annuity. But other payment periods are available. If you do not receive regular, periodic payments, the tax rules are different than those discussed here.
Under the General Rule, your investment in the contract is returned tax-free over the period the payments are received. Part of each payment is a return of your investment (or net cost), and part is a payment of taxable income.
Your net cost or investment is determined by first adding the total premiums, contributions and other amounts you paid into the contract. Only after-tax amounts are included. If a contribution was deductible or excluded from your income, it is not part of the net cost. Employer contributions to the annuity are included only if they were included in your gross income.
From this total, subtract refunded premiums, rebates, dividends and unpaid loans as of the annuity starting date. Also, subtract any additional premiums paid for double indemnity or disability benefits and any tax-free distributions received before the annuity starting date. Other adjustments might be required for death-benefit features and refund features of the annuity. As you can see, the simpler the annuity, the easier it is to compute the taxable portion.
Next, you determine what the tax code calls your expected return, which simply is the total amount you are expected to receive under the life of the contract. For this calculation, use your age closest to the annuity starting date. The calculation of the expected return depends on the type of annuity payout. Here’s how to apply the rule to some of the more popular payouts.
Fixed-period annuity: This annuity makes payments for a fixed number of years. When the payments are monthly, multiply the monthly payment amount by the fixed number of months for which payments are to be made.
Single-life annuity: These are fixed payments for your life. Multiply the total of the payments to be received in one year by your life expectancy from Internal Revenue Service tables. Use the expectancy from either Table I or Table V from IRS Publication 939, whichever table applies to you. You need to adjust the life expectancy if payments are other than monthly.
Here’s an example:
Max Profits is 66 at his birthday nearest the annuity starting date and will receive $500 monthly. His annual payment will be $6,000. This is multiplied by the factor from Table V, which is 19.2. The expected return for Max is $115,200.
Joint and survivor annuity: If the periodic payment will not change after the owner’s death, the expected return is based on the joint life expectancy. The calculation is the same as for the single-life annuity except Table II or Table VI is used to determine life expectancy.
Here’s an example: Max Profits is 70 at the annuity starting date nears, and his wife Rosie is 67. The annuity will pay $500 monthly over the lives of both Max and Rosie. The factor from the table is 22.0. The annual payment is $6,000. This is multiplied by 22, for an expected return of $132,000.
The calculation has more steps if the payment declines after the owner’s death. There also are other payment schedules possible, and the methods for calculating their expected returns are discussed in IRS Publication 939.
Now, you know your investment in the contract and your expected return. With this information you can calculate the taxable and tax-free portions of the annuity payments.
Divide the investment by the expected return. The result is the exclusion percentage. This is the percentage of each payment that will be excluded from gross income. When your first regular periodic payment from the annuity is received, multiply that amount by the exclusion percentage. The result is the dollar amount of each annuity payment that is tax-free. The excluded amount does not change in most cases, even if the amount of the payment changes.
When doing your tax return, multiply the tax-free amount by the number of payments received during the year. This is your tax-free amount for the year. Subtract the tax-free amount from the total payments received during the year, and the result is the taxable portion of the annuity payments. After the end of the year, the insurer making the payments should send you a Form 1099 that shows the total amount you were paid during the year.
Over your life and that of any beneficiary, the total amount excluded from gross income cannot exceed your investment in the contract. It should work out that you have excluded from gross income your total investment in the contract when you reach the life expectancy in the IRS tables. After your full investment is excluded from gross income, all of each subsequent payment is included in gross income. If you and any beneficiary die before the full investment is recovered, any unrecovered investment qualifies as a miscellaneous itemized deduction on the final tax return of the last to die.
It should work out that if you live to life expectancy or less, part of each payment to you will be tax-free. If you live beyond life expectancy, the payments beyond that point will be fully taxable.
The insurer or other entity making the payments is required to withhold income taxes from each payment unless you request zero withholding. You also can request higher withholding. Having extra taxes withheld might save you the burden of computing and paying estimated taxes on your other income each quarter and help avoid penalties for underpayment of estimated taxes. Consider estimating your total income taxes for the coming year and requesting this amount be withheld from annuity payments instead of only the amount of taxes generated by the annuity.
Those are the basic rules for minimizing taxes on annuity payouts. There are additional rules for non-standard situations and other types of annuities. You can find more details — along with examples, worksheets and the actuarial tables — in IRS Publication 939, General Rule for Pensions and Annuities. For payments from qualified retirement plans, the rules are in Publication 575, Pension and Annuity Income. Each is free from the IRS website at www.irs.gov.
You need to consider every option for reducing taxes on your retirement income. Be sure you aren’t paying a dime more than you have to on your annuity payouts.
— Bob Carlson