Taxation of Annuities Flashcards
Individual Annuities
Tax-qualified annuities are generally funded with pretax dollars. They’re also fully taxable at ordinary income rates when money is withdrawn because the premiums paid and subsequent premiums do not establish a cost basis. Non-qualified annuities are generally funded with after-tax dollars.
In simple terms, the cost basis equals the total amount paid for a deferred annuity.
If the policy is cashed out for a lump-sum, then any amount received in excess of the cost basis is taxable as ordinary income.
If the policy is annuitized, then the original investment is returned in equal tax-free installments over the payment period. These payments are not taxed since they are simply a return of principal, while the balance of monies received in annuity payments is the taxable gain or earnings.
This is taxed at ordinary income tax rates even if the gains come from the investment separate accounts found within a variable annuity.
Exclusion Ratio
in general, the way in which taxation of annuities is computed is referred to as the exclusion ratio.
After the entire cost basis is recovered, any future income benefit payments received are fully taxable.
A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. Investments are taxed on a last-in, first-out (LIFO) basis. Additionally, withdrawals made prior to the annuitant’s age 59½ are generally subject to a 10% early withdrawal penalty.
Distributions at Death
When the annuitant dies during the accumulation phase of the annuity, the beneficiary receiving the death benefit must pay income tax on any gain embedded in the policy, at ordinary income tax rates.
Estate Taxation
During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owner’s estate for valuation. If the annuitant dies during the annuity payout phase, the remaining value in the account is added to the deceased annuitant’s estate for valuation.
Corporate-Owned Annuities
An annuity contract owned by a non-natural person is not treated as an annuity for federal income tax purposes, so the contract‘s gains are currently taxed as opposed to being tax deferred. In short, there are no tax benefits when an annuity is owned by a corporation.
