Having spent the last 26 years either in product development, marketing or sales of fixed annuities, it felt like a no-brainer when asked for a “primer” on their taxation.
At the National Association for Fixed Annuities, we live and breathe fixed annuities. As we often say, we have only one master and that is the fixed annuity. When your focus is so singular day in and day out, year after year, there is little you don’t know about the object of that focus and what you do know is second nature.
But as we sat down to write the primer, we found it a very daunting task indeed. As if to mock our complacency, initial research uncovered a cacophony of books, articles and Web sites dedicated to the sole purpose of explaining the taxation of annuities. How could something simple create so much noise? We also found that all too often the discussion is simplified to such a degree that it leaves big black holes where the taxman may lurk.
As a primer, this article is an introduction to annuity taxation – a starting point. While we are now convinced this is not a simple topic, we can and will frame it so you have the general principles and concepts to point you in the right direction and ask the right questions that may apply to your own situation. As with any tax issue, NAFA always recommends that whatever your situation, you consult with a tax professional.
From a tax planning perspective, the basics of fixed annuity taxation begin with www – not World Wide Web, but What, When and Who.
What refers to the type of annuity – qualified or nonqualified. Qualified annuities are annuities purchased through your employer-sponsored retirement plan, or individually through an IRA. A nonqualified annuity is not part of an employer-provided retirement program and is typically purchased by any individual, but it may be purchased by what the tax code calls a “non-natural person,” such as a trust.
When refers to the timing of the distribution. Deferred annuities have two phases following their purchase – the accumulation (deferral) phase and the payout phase (called annuitization). Immediate annuities typically have just one phase – the payout phase – because payouts occur upon purchase.
Who refers to whom, and in some cases to what the funds are paid. There are three different types of parties and payees in an annuity contract:
1. The owner is the individual or entity who purchases the annuity, designates the annuitant and the beneficiary, determines payout options and may take withdrawal.
2. The annuitant is generally the person who receives the payment at annuitization or payout of the annuity. It can also be the person whose age is used to calculate payments to another entity. In many cases, the same individual is both owner and annuitant.
3. The beneficiary is generally the person who receives the death benefit of the annuity if the owner dies before the annuity starting date or who becomes the owner upon the original owner’s death on or after the annuity starting date.
What: Qualified annuities
Who: The owner
Contributions and earnings
Qualified annuities act like any other IRA or 401(k) plan. When purchased through an employer and funded with money from a paycheck, they are funded with pre-tax income. In other words, the salary the employer reports as income is reduced by the amount contributed to the qualified plan (subject to certain restrictions and limits).
When purchasing a qualified annuity privately, the owner is allowed to take a tax deduction. The amount of the deduction allowed depends on adjusted gross income that is reported to the IRS and if the owner participates in an employer-sponsored plan like a 401(k) in addition to the privately purchased qualified annuity.
You can find many guides on the Internet for the ranges of deductibility. In addition, there are many good Web sites where you can simply input the AGI, the filing status and whether the individual and/or individual’s spouse contributes to an employer-sponsored plan. One of the simplest calculators is provided by Wells Fargo at www.wellsfargoadvantagefunds.com.
Regardless of whether the owner purchased the qualified annuity or it is provided through an employer, the interest earned during the accumulation phase is not taxable until it is withdrawn. Therefore, during the accumulation phase both the qualified contributions and the interest earned are free from income taxation.
Generally, with some exceptions, contracts owned by “non-natural” persons are subject to annual tax on the inside buildup in the contract. Examples of non-natural persons include corporations, partnerships and certain trusts. For the purposes of this article, we will limit our discussion to the taxation of “natural” persons
Again, a qualified annuity acts like any other qualified account, such as an IRA, 401(k), profit sharing plan, or other tax-deferred retirement account and is taxed the same in almost all cases. The government does not require any money be taken out prior to age 701/2, but should it be done, all that is taken out is subject to ordinary income tax. If money is taken out prior to age 591/2, it is subject to an additional penalty (excise) tax of 10 percent. At age 701/2 the owner must begin minimum withdrawals. The amount required is different based generally on the annuity’s account balance and the owner’s age. There are additional details to consider and, again, you should consult a tax professional.
What: Qualified annuities
Who: The beneficiary
Spouses: The IRS allows the surviving spouse to treat a departed spouse’s IRA as her own. The surviving spouse may roll the deceased’s IRA to one of her own and continue the tax deferral.
Non-spousal beneficiaries: All other beneficiaries must take and be taxed on a distribution from an inherited traditional IRA. Typically non-spousal beneficiaries have two choices on how to take distributions: