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Taxation of Annuities

Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

Annuities are instruments that can be harnessed to ensure income during retirement. However, the IRS also wants a piece of the action: This lesson will cover the tax implications and rules for annuities.

Taxation of Annuities

An annuity is an investment instrument that promises income over a given time span. It is made between you and a third party, usually an insurance company. The annuity promises asset growth over time and a death benefit.

Immediate Annuity

An immediate annuity starts paying right away. If you pay with after-tax money, a part of each payment from the annuity is taxable earnings. However, your original investment is paid out in equal tax-free installments over the length of the payment period. If the payments are set to stop when you die, the IRS determines the payment period up to the life expectancy for someone your age. Taxes are owed only on parts of the payout after the tax-free return.

In order to understand how this works, consider the following example. You open an annuity account with $50,000 in post-tax dollars. The annual payments are $3,000. The IRS thinks you will live another 25 years. Divide $50,000 by 25 to figure out the amount of each tax-free payout. In this case it is $2,000. Therefore, $2,000 from each $3,000 payout is tax-free. The rest is taxed as ordinary income.

Deferred Annuity

Unlike an immediate annuity, a deferred annuity, you may not have any payouts for years. These are used to invest for retirement: You usually buy the annuity while you're working and the money grows tax-free. Taxes are paid upon withdrawal.

If you bought the annuity with pre-tax dollars, the ENTIRE balance is taxable. But, if you purchased with after-tax dollars, only the earnings are taxed.

However, if you take out the entire amount in a lump sum, you'll pay income taxes on all earnings over and above your original investment. If you withdraw in installments, the IRS taxes the money as interest and earnings: which means you'll be taxed on ALL withdrawals until all interest and earnings are withdrawn from the account. Once that is done, the principal can be taken out tax-free.

Let's look at an example:

You invest $100,000 in a deferred annuity. Over the life of the annuity, it grows by $30,000 to $130,000. The first $30,000 that is taken out is taxable earnings, meaning you'll be paying taxes on all withdrawals until you can take out the original $100,000 tax-free.

One option to avoid tax complications is to annuitize the withdrawal. This basically converts the deferred annuity into an immediate annuity; payments are made from the principal for life. Since the payments are from the principal, they are tax free. (Any withdrawals over and above the original principal would be taxed.)

Why Invest in an Annuity?

Annuities are viable retirement savings plans. There are many reasons for or against investing in them (a conservative safe investment; assured income; etc.). We'll focus on the tax reasons.

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