Nonqualified Annuities – Tax Benefits

 

Tax Issue

Nonqualified annuities offer tax-deffered earnings. However, upon distribution, nonqualified annuity earnings are taxed as ordinary income. Nonqualified annuity withdrawals are treated an income-first, meaning that the earnings are withdrawn before removing the principal. In addition, if the taxpayer is younger than 59 ½, withdrawals of earnings are generally subject to an additional 10% tax.

 

Other investment income, such as stock or mutual fund dividends, is often taxed as qualified dividends at a lower rate than ordinary income. In addition, equity investments help for greater than one year are generally taxed at a lower capital gains rate when sold. In comparison, this could lead a taxpayer to believe that there is no tax benefit to a nonqualified annuity. An annuity, however, offers a taxpayer the ability to turn income on and off as needed, or as the individual tax situation dictates. In addition, an annuity owner can exchange the value of the annuity for a guaranteed income which represents a pro-rated amount of earnings and principal. The annuity owner can generate a larger income amount without the entire income being taxed.

 

Applicable Tax Law

• Earnings on annuities grow on a tax deferred basis. As long as earnings are not withdrawn, there is no current income tax due.
• Earnings on annuities are taxed at ordinary income tax rates when withdrawn.
• Earnings on annuities are generally subject to a 10% additional penalty when withdrawn before age 59 ½.
• Withdrawals from annuities issued post-TEFRA (after August 13, 1982) are on a last-in-first-out (LIFO) basis.

Tax Planning Strategies

Non-qualified annuity owners can minimize the tax implications on payouts from annuities by structuring the type of withdrawal to match their income tax situation. Payouts can be structured either by taking lump-sum withdrawals or by annuitizing the contract.

Lump-sum withdrawals. Withdrawals can be taken from an annuity (prior to annuitization of the contract) by removing lump-sum amounts. Annuity withdrawals are taxed on a LIFO basis. That is, the earnings are withdrawn first. Once the earnings have been exhausted, the principal amount is removed tax free. Utilizing lump-sum withdrawals allows a taxpayer to keep the account intact and manage the taxable income.

By utilizing personal exemptions and the standard deduction, taxpayers can take advantage of tax years in which they otherwise have no taxable income to withdraw earnings from annuities. While use of the personal exemption and standard deduction applies to other taxable income, it is important to note that annuities give the taxpayer the ability to decide whether to take the income or not. Earnings from stocks, bonds, mutual funds, CDs, and other income-earning assets generally force income to the taxpayer through dividend or interest distributions, thereby causing the taxable event based on something other than the taxpayer’s choosing.

 

Annuitization. A taxpayer can choose to receive a series of guaranteed payments in return for the value of the annuity. The series of payments can be for a set period of time, such as 10 years, or can be for the lifetime of the taxpayer. By selecting the series of payments, the earnings on the annuity are spread out over the period of time selected. Each annuity payment the taxpayer receives includes a portion of earnings and an amount excluded from income (principal amount). Although the earnings portion of the payment is taxed as ordinary income, receiving the distribution this way makes the taxable amount less than simply taking a one-time withdrawals from the annuity. In addition, a taxpayer younger than 59 ½ receiving the series of payments is not subject to the additional 10% tax.

 

Examples

 

Example #1: Mary, a single taxpayer age 65, has an annuity she invested $50,000 of after-tax money in 10 years ago. In 2012, it is worth $80,000. For 2012, Mary’s only income is from Social Security income ($25,000 per year) and has no need to take money from any other source. However, Mary can remove $11,200 from her annuity and not pay any tax by utilizing her personal exemption and standard deductions.

 

Income from the annuity …………………………$11,200

Less standard deduction ………………………….(5,950)

Less personal exemption …………………………(3,800)

Less age 65+ additional standard deduction ..(1,450)

Taxable income………………………………………..$      0

 

Mary is able to remove taxable earnings from her annuity and not pay tax on it. Meanwhile, her accumulated earnings in the annuity are reduced from $30,000 to $18,000. Mary should evaluate her taxable income each year to remove all the taxable earnings she can from her annuity without generating additional tax.

 

Example #2: Jim is 65 and needs an additional $9,000 of income each year. He owns an annuity worth $100,000 that has a basis of $60,000. For 2012, Jim is in the 25% tax bracket. If he withdraws $9,000 from the annuity, he will pay $2,250 in federal income tax because he is withdrawing earnings first. Instead, Jim decides to annuitize the contract, receiving payments of $750 per month ($9,000 annually) in exchange for the value of the annuity. In doing so, only a portion of the $9,000 is taxable because a portion of the monthly payout is principal.

 

Conclusion: Nonqualified annuity earnings eventually are taxed at ordinary income rates. By structuring the withdrawals, or by using annuitization, the taxpayer can lessen the immediate tax burden.

Possible Risks

• Most annuities require forced annuitization by a certain age, usually 85 or 90. Tax planning for annuity withdrawals needs to take place several years in advance to maximize the benefits of the strategies.
• Annuity contracts generally have a surrender charge (sales charge) attached to withdrawals made within a certain number of years from when the annuity is purchased. The amount of the surrender charge and length the charge is in force can vary greatly from one insurance company to another. In addition, surrender charges can be applied differently depending on the contract. For example, and annuity with Company A may allow a withdrawal of earnings only at a no charge for each year during the surrender charge period. Company B may allow a 15% withdrawal based on the principal amount at no charge. Company C may allow a 10% withdrawal based on the entire contract value (principal plus accumulated earnings) at no charge. Withdrawals in amounts above the “free withdrawal” amounts are subject to a surrender charge.
• Annuitization essentially removes an asset form the taxpayer in exchange for a guaranteed income for a set period of time, or for the life of the owner. Once annuitized, the taxpayer can no longer make lump-sum withdrawals from that contract.
• Annuitization forces a taxpayer to take income and pay tax on a portion of it each year. There may be years when a taxpayer does not need the income. Once annuitization payouts begin, it generally cannot be reversed.
• Annuitization of a contract for a period equal to the life of the owner carries the risk of loss because of an early death. For example, a taxpayer who annuitizes a $100,000 contract to receive payments of $800 per month for the rest of his or her life would be shortchanging the beneficiaries if the taxpayer died shortly after annuitization.
• Annuities owned by someone other than an individual, such as a trust or corporation, have more complex tax implications.
• The use of these strategies assumes tax-deferred earnings exist within the annuity. Because variable annuities can be invested in the markets, it is possible an annuity may have no earnings accumulated or have decreased in value below the basis amount.