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
When: Accumulation
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

Distributions

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
When: Accumulation
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:

1. Lump sum: No later than December 31 of the fifth year following the IRA owner’s death, non-spousal beneficiaries may cash in the IRA without penalty, pay ordinary income taxes, and keep what’s left. This distribution procedure is known as “the 5-year rule.”

2. Periodic payouts: Non-spousal beneficiaries may have the IRA proceeds paid out over their own life expectancies and pay ordinary income taxes on the amount distributed each year. The election to have the IRA distributed over their lifetimes must be made and implemented no later than December 31 of the year following the year of the IRA owner’s death. If the election is not made by that date, all the proceeds must be withdrawn and taxed using the previously discussed 5-year rule.

What: Nonqualified annuities
Who: The owner
When: Accumulation

Contributions and earnings

Because it is not a part of an employer-provided plan or tax-deductible IRA, contributions to nonqualified annuities are made with after-tax dollars. The contributions are not deductible from gross income for income tax purposes. The interest earned during the accumulation phase of the annuity is not subject to income taxation.

Withdrawals

When an annuity contract is fully surrendered (not exchanged for another annuity contract) during the accumulation phase, the owner must pay income tax on the earnings in the contract. The owner is not taxed on amounts that represent a return of premiums contributed to the contract.

Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis. In order words, withdrawals from an annuity are considered interest earnings first, and the owner is taxed on the payments until all of the interest earnings have been distributed. There is an exception to the interest-earnings-first rule for contributions made to annuity contracts prior to Aug. 14, 1982. These contributions are distributed on a first in, first out (FIFO) basis and the owner is not taxed until these contributions are fully recovered.

There is an aggregation rule, which requires that all annuity contracts issued by the same company to the same owner in the same calendar year must be treated as one annuity contract for purposes of determining the taxable portion of any distributions.

If income is withdrawn before age 591/2, the IRS usually will apply a 10 percent penalty in addition to ordinary income tax, similar to the penalty for early IRA withdrawals. However, there are exceptions for distributions: (1) made as a result of the owner’s death or disability; (2) made in substantially equal periodic payments over the life or life expectancy of the owner, or joint lives or joint life expectancy of the owner and designated beneficiary; (3) made under an immediate annuity; or (4) attributable to investment in the annuity made prior to Aug. 14, 1982.

What: Nonqualified annuities
When: Accumulation
Who: The beneficiary

If the owner dies during the accumulation phase, the beneficiary is paid a death benefit and, in most cases, avoids the costs and delays of probate. Generally, a beneficiary who inherits an annuity before distribution begins can request a lump-sum distribution without penalty, but will be subject to full taxation on the accrued interest or gain on the contract. As with qualified annuities, a spouse who inherits an annuity before distribution has begun can step in as the new owner of the annuity and the tax deferral continues until amounts are withdrawn.

What: Nonqualified annuities
When: Annuitization
Who: The annuitant

While the owner and the annuitant may be the same individual during this phase, the Who is the annuitant (the person on whose life expectancy payouts are determined and to whom payments are made) or, if the annuitant dies before payouts are completed, the Who is the beneficiary.

The payment may be made as one lump sum, random withdrawals, or as a series of scheduled payouts over a specific period or a lifetime. These payments are taxed in various ways.

If the payment is made as a lump sum, income taxes will be due on the difference between the amount paid into that annuity and its value when paid back.

Just like a traditional IRA, withdrawals made prior to the annuitant’s age 591/2 are generally subject to a 10 percent early withdrawal penalty.

When the contract is annuitized (a series of scheduled payouts over a specific period or a lifetime), part of each payment is considered a return of previously taxed principal and part as earnings. The taxpayer will owe income taxes on the part of the payment that is considered earnings. The amount of each annuity payment that won’t be taxed is computed using an exclusion ratio, which is determined by dividing the premium paid into the contract by the total amount expected to be distributed during the payout period.

Assume Dick, age 62, has a fixed annuity into which he paid $100,000 of premium and will receive payouts of $700 a month for the rest of his life. According to IRS life expectancy tables, Dick will receive those payments for 22.5 years, so the contract’s value is $189,000 (12 x 700 x 22.5). The exclusion ratio is 52.9 percent (100,000/189,500). Out of the $8,400 the annuity pays each year, Dick may exclude $4,444 from income. If payments begin at a point during the year or for a fraction of the payout period, the tax law provides the method to determine the taxable portion.

What: Nonqualified annuities
When: Annuitization
Who: The beneficiary

If distribution payments had begun and the annuitant dies, the benefits would generally have to be distributed to the beneficiary at least as rapidly as through the method in effect at the time of the annuitant’s death. Taxation will continue to apply to those proceeds based on the beneficiary’s ordinary income tax.

Conclusion

There you have it – a primer on fixed annuity taxation. NAFA cannot emphasize enough that this article should not be relied upon as a tax resource or definitive statement on tax rules for annuities. Many more factors and circumstances may change the way a particular annuity is taxed. To name a few: whether it is a variable or fixed annuity; when the ownership of an annuity is transferred or assigned collaterally; when ownership is by a trust or charity; or the type of annuity payout option. Any of these influence when and how much taxation exists. NAFA strongly advises consulting a tax professional for a complete understanding of every situation.