Annuities and Taxation

The Basics

A personal tax advisor should always be consulted, as insurance agents are not trained or qualified to provide tax advice. The understanding of basic annuity taxation only allows an agent to help people accumulate more money, not provide tax advice.

Ten Percent Excise Tax Penalty

Tax advantages are extended for retirement purposes by the government. Tax advantages are also extended to the taxpayers who do not use the annuity for retirement. All interest withdrawn before the owner attaining the age of 59½ is subject to a 10 percent excise tax penalty. However, the 10 percent excise penalty can be avoided under certain circumstances.

Taxpayer disability:

• Distribution from a pre-8/14/82 annuity
• Death of owner (but the death of annuitant for annuities issued before 4/23/87)
• Payment from an immediate annuity where benefits commence within one year of purchase
• Payment from a structured settlement
• Substantially equal payments over the taxpayer’s life expectancy

Exclusion

The annuitant will receive equal payments when and if the owner annuities (applies their annuity value toward a settlement option). Unlike withdrawals, the contract owner does not pay full taxes on the payments. An exclusion ratio is applied to each payment received, which stipulates that a percentage of each payment is considered a return of the owner’s cost basis, and is tax-free. The balance, however, is taxable.

The exclusion ratio can be calculated by dividing the expected return into the total of all premiums paid into the contract.

Effective with all annuities-starting dates after 12/31/86, payments become fully-taxable after the owner recovers the total of all premiums paid into a contract (determined by adding all dollars excluded from taxes). After the contract owner has lived beyond his life expectancy (as calculated when payments began), payments then become fully taxable.

Withdrawal

Depending upon the annuity purchased, withdrawals can be taxed in one of two ways. Before 8/14/82, annuities were structured with FIFO accounting (first in, first out), which allowed the principle to remain tax-free. On 8/14/82 and after that, annuity taxation changed to LIFO (last in, first out), which allowed for taxation on withdrawals since interest is withdrawn early. This is appealing to the customer since most are now paying taxes on interest even if they do not withdraw it.

Section 1035 (A) of the Internal Revenue Code (IRC)

Section 1035(a) of the Internal Revenue Code provides the ability to transfer money from one annuity to another annuity income tax-free. Note that such transfers should be reviewed carefully.

The Contract Owner may elect to perform any of the following:

• Assign the old annuity contract (if premiums are non-qualified) to the new insurance company
• Exchange the entire annuity (cannot transfer some of the money)
• If loans are outstanding, repay loans before exchanging
• Parties designated in the old contract as the owner, annuitant and/or the beneficiary should again be identified in the new contract
• Customers should consult with their tax advisers before the exchange

Annuity Taxation Basics

• Assign the old annuity contract (if premiums are non-qualified) to the new insurance company
• Exchange the entire annuity (cannot transfer some of the money)
• If loans are outstanding, repay loans before exchanging
• Parties designated in the old contract as the owner, annuitant and/or the beneficiary should again be identified in the new contract
• Customers should consult with their tax advisers before the exchange

For more information about annuity taxation, please contact Healthcare American today!