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Income Taxation of Annuities, When and On What?
by Shane
Flait, ©2008
An annuity
is both a contract with an insurance company and an
investment. Your contributions (often called premium
payments) to it are invested to produce earnings.
This article explains when and what is taxed as
income under annuitization, withdrawals, and gifts
of your annuity.
An annuity
has
two phases: accumulation and annuitization. During
accumulation – called a deferred annuity - both your
contributions (i.e. premium payments) and their
earnings accumulate within the contract. During
annuitization (i.e. payout stage) you receive
monthly payments while money remaining in the
contract creates more earnings.
Most
annuities are nonqualified. You can make unlimited
after-tax contributions to them and their earnings
grow tax-deferred. Only the tax-deferred earnings
are eventually subject to income tax; your
contributions come out tax-free as a return of your
basis in the contract.
A qualified
annuity is one regulated under government rules as a
retirement plan. All contributions to them are
deductible from income but, of course, must come
from working income. Annual contributions are
limited like IRA contributions. Since they have no
after-tax contributions, your tax basis in the
contract is zero; so all withdrawals will be
subjected to income tax.
Like all
qualified plans, any withdrawal you make before
reaching age 59½, will have a 10% penalty tax
imposed on it in addition to income tax. After
reaching 70½, you’re required to make minimum
required distributions – just like IRAs.
Income
taxation is imposed on
·
Annuitization
·
Accumulation
withdrawals
·
Gifts of an
annuity, and
·
Beneficiary’s
withdrawals
Let’s see how
nonqualified annuities are taxed:
Taxation on
annuitization payments:
Your monthly
payouts are considered as made up of a contribution
part and an earnings part. Only the earnings part is
taxed as income. It’s a specific fraction of your
payment equal to total earnings divided by the
contracts total value – i.e. earnings plus
contributions. After you’ve received all your
contributions back in payouts, all future payouts
are fully taxed as income.
Taxation on
withdrawal from your deferred annuity accumulation:
Taking money
out of your deferred annuity is a withdrawal. But
earnings are considered to come out first. So
anything you withdraw is taxed as income until all
the earnings are out. Any withdrawal beyond earnings
is a tax free return of basis.
Until you’ve
turned 59 years old, the IRS imposes a 10% penalty
tax on what you take out of your nonqualified
annuity too.
This
withdrawals taxation also includes cashing out your
deferred annuity altogether. An early cash out may
trigger an additional fee from the annuity company.
Taxation on
a gift of your deferred annuity:
Gifting your
deferred annuity to a person, charity or a
charitable remainder trust, triggers income tax on
the annuity’s earnings; that includes any 10%
penalty tax too.
For gifting
to a government-approved charity, your deduction is
limited to your basis in the contract – i.e. the sum
of your contributions.
Qualified
annuities are taxed as above accept they have no
basis – i.e. basis equals zero.
Taxation on
beneficiaries and survivors:
Annuities
that go to beneficiaries and survivors are
considered as ‘income in respect of a decedent’ –
and not as an investment. So an annuity – unlike an
investment – doesn’t get a stepped-up basis.
So, any
annuity payout to survivors and beneficiaries is
subject to income tax – but only to the extent that
money paid out to them exceeds the annuity’s basis
-i.e. the original owner’s annuity contributions. So
a portion of each payout will be attributed to the
deferred tax on the earnings of those contributions
and a portion will be return of basis.
As it was
for the original owner, when the basis has been
completely recovered through payments to the
beneficiary, all further payments will be fully
taxed as income.
Shane Flait is a writer and educator. Get more info
at
www.EasyRetirementKnowHow.com
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