If your clients are like most, come tax time they’ll have a number of questions for you, their trusty financial advisor. What penalties apply to premature distributions? What if I made a partial lump sum withdrawal last year, and am now taking a reduced annuity? Without further ado, here are the answers to eight questions annuity holders frequently ask.
Q: How are annuity payments taxed?
A: The basic rule for taxing annuity payments (i.e., “amounts received as an annuity”) is designed to return the purchaser’s investment in equal tax-free amounts over the payment period and to tax the balance of each payment received as earnings. Each payment, therefore, is part nontaxable return of cost and part taxable income. Any excess interest (dividends) added to the guaranteed payments is reportable as income for the year received.
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Q: Are dividends payable on an annuity contract taxable income?
A: Taxation of dividends under an annuity contract depends on when the contract was purchased. If the contract was purchased after August 13, 1982, dividends received before the annuity starting date are taxable to the extent the cash value of the contract (determined without regard to any surrender charge) immediately before the dividend is received exceeds the investment in the contract at the same time. If there is no excess of cash value over the investment in the contract (i.e., no gain), further dividends are treated as a tax-free recovery of investment. If the annuity contract was purchased before August 14, 1982, and no additional investment was made in the contract after August 13, 1982, the dividends will be taxed like dividends received under life insurance contracts (generally tax-free until basis has been recovered).
. IRC Sec. 72(e).
Q: What penalties apply to “premature” distributions under annuity contracts?
A: To discourage the use of annuity contracts as short term tax sheltered investments, a 10 percent tax is imposed on certain “premature” payments under annuity contracts. The penalty tax applies to any payment received to the extent the payment is includable in income. There are nine exceptions to the penalty tax.
.IRC Sec. 72(q).
Q: What is the tax treatment of dividends where annuity values are paid in installments or as a life income?
A: Dividends received before the annuity start date or the first date that an amount is received as an annuity, whichever is later, are included in the recipient’s gross income to the extent that those dividends, taken with other amounts received under the contract that were excludable from gross income, are greater than the total premiums (or other consideration) paid by the recipient to that date. Also, dividends thus received must be subtracted from the consideration paid for purposes of the exclusion ratio that will be applied to payments received from the annuity after the date of the dividend.