As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
Q: How are payments under a variable immediate annuity taxed?
Both fixed dollar and variable annuity payments received as an annuitized stream of income are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser’s investment, and the balance is taxable as ordinary income. In the case of a variable annuity, however, the excludable portion is not determined by calculating an “exclusion ratio” as it is for a fixed dollar annuity. Because the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract.
Thus, the excludable portion of each payment is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid. In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.
A portion of each payment is only excluded from gross income using the exclusion ratio until the investment in the contract is recovered (normally, at life expectancy). However, if payments received are from an annuity with a starting date that was before January 1st, 1987, payments continue to receive exclusion ratio treatment for life, even if the total cost basis recovered exceeds the original investment amount.
Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of the year’s exclusion.
If an annuity settlement provides a period-certain or refund guarantee, the investment in the contract must be adjusted before being prorated over the payment period.