What Are Taxes on a Lump Sum Payout of an Annuity?

Of course, if the contract owner takes a lump sum settlement at maturity, the contract owner must include the gain in gross income for the year in which he or she receives the payment.

Are there any considerations that a taxpayer should be made aware of when deciding whether to surrender an annuity or accept a buyback offer?

Taxpayers who purchased variable annuities with a view toward generating retirement income may be facing buyout offers from an issuing insurance company, notices that their investment choices are being limited to those that are very conservative, or may simply find themselves facing changed circumstances so that the product no longer makes sense.

For example, a taxpayer who has recently been diagnosed with a disease that is likely to shorten his or her life expectancy may find that surrendering the annuity in exchange for a lump sum payout may better serve his or her reduced need for lifetime income. Other taxpayers may be facing unanticipated expenses and see the buyout as a way to meet those expenses.

Taxpayers facing the need for an immediate lump sum of cash should also be aware that it may be possible for them to withdraw a portion of the annuity’s assets, keeping only a small part of the initial investment in the annuity to maintain the contract’s death benefit. Taxpayers who are simply unhappy with the variable annuity’s investment performance may also find this strategy appealing, as they can then invest in another income-producing product while preserving some value in the original annuity.

For taxpayers who are still attracted to the income-producing feature of a variable annuity, however, it might be best to hold on to the product in the face of a buyout offer, especially if the product offers guaranteed returns that may be unavailable in a replacement product.

After a taxpayer has determined that his or her best interests will be served by surrendering the product, the surrender charges associated with the annuity still must be taken into account. If the taxpayer has a buyout offer on the table, it is likely that the insurance company has already offered to waive any surrender charges. If the taxpayer has independently decided to surrender, however, the taxpayer may be able to negotiate a waiver, especially if the taxpayer agrees to reinvest the recovered annuity funds with the same carrier that issued the surrendered product.

It is important that taxpayers realize they will owe taxes upon any gain realized at the time of surrender. If the taxpayer has only held the annuity product for a few years, this gain might not be substantial—in fact, many variable annuity products that were issued just before the economic downturn in 2008 are just now returning owners to the break-even point. Still, for taxpayers who have owned the variable annuity for many years, the tax liability can be substantial—especially when the new 3.8 percent investment income tax for high earning taxpayers is taken into account.

For taxpayers who purchased the annuity product within an IRA, the funds can be transferred in a trustee-to-trustee type rollover transaction, which allows the taxpayer to defer taxation until the funds are withdrawn from the IRA. Taxation can also be deferred if the taxpayer exchanges the undesirable annuity for another annuity product in a tax-free exchange under IRC Section 1035.

(Related: Qualified Longevity Annuity Contracts and Retirement Planning)