Taxation of Deferred and Immediate Annuities Explained
In the workshops and classes I teach, I often remark that “one good thing about deferred annuities is that they get tax deferral (that the interest earned is not taxed until it is distributed in a withdrawal or surrender); one bad thing about them is that they get tax deferral”.
That’s not merely a lame joke. It’s a recognition that tax advantages always come with a cost. In the case of deferred annuities, the “cost” of tax deferral is twofold:
- All distributions from any annuity, whether taken during lifetime or after death, to the extent that they’re taxable, are always taxed as “Ordinary Income” (just like interest on a Certificate of Deposit); no annuity distribution is ever eligible for capital gains treatment.
- Distributions taken prior to the annuity owner’s age 59 ½ will be subject to a 10% penalty tax (10% of the distribution that is includible in income) unless an exception applies. You can find the exceptions here.
What does this mean? It means that, in this author’s opinion, if your goal is long term wealth accumulation, such as saving for retirement, a deferred annuity can be a very useful and powerful tool; but it’s a very poor instrument for short term savings (with the possible exception of those MYGAs).
But what does “distributions, to the extent includible in income” mean?
While the taxation of annuities can be very complicated (I’ve written a book on the subject – “Taxation and Suitability of Annuities” – www.indexannuitybook.com), the general rules are these:
Immediate (“payout”) annuities: A part of each annuity payment is not taxable, because it’s treated as a return of principal. The balance is taxed as “Ordinary Income”. If you’re thinking of purchasing an immediate annuity, be sure that you understand how much of each annuity payment would be nontaxable and how long that tax treatment will last. If your agent cannot answer both questions, find another agent.
Deferred annuities: For annuities issued since August 13th, 1982, all distributions from a deferred annuity are taxable as Ordinary Income, to the extent that they represent “gain” (interest). After all “gain” has been distributed and taxed, subsequent distributions of “principal” (the money the purchaser originally contributed) are tax-free.
Example: Karen purchases a deferred annuity for $25,000. Four years later, when the contract is worth $27,000, she withdraws $5,000. $2,000 of that distribution is taxable (as Ordinary Income); the remaining $3,000 is tax-free as a “return of principal”. But that withdrawal may also be subject to a contractual surrender charges. (If her annuity allows penalty-free withdrawals of up to 10% of the contract value, she would pay a penalty on $2,300 of that withdrawal ($27,000 x 10% = $2,700 / $5,000 – $2,700 = $2,300). The penalty will be whatever percentage the surrender charge schedule specifies for withdrawals in Year 4.
Important Note: The tax treatment described in this article applies only to”non-qualified” annuities – annuities purchased outside IRAs or Employer-Sponsored Retirement Plans. The taxation of annuities inside such plans is governed by the tax rules applying to such plans.
If the reader is a bit dizzy at this point, that’s understandable. Annuities, immediate and deferred, fixed and variable, can be very valuable tools. The income that they guarantee can be for life, no matter how long you live. They offer substantial tax advantages (but at the costs described above). But you should not purchase any annuity unless you understand its costs and benefits. Ask questions. Test your understanding by explaining to your agent how you think the annuity works and when costs, fees, and penalties may apply; then ask him or her if your understanding is correct. Truly professional agents will welcome this.
This article is NOT a solicitation for any type of annuity sale. If you find any of the content confusing or just want additional information, you may wish to purchase one of my books listed below:
- The Annuity Advisor, written with my friend Michael Kitces (National Underwriter Co., 3rd ed., 2012 – http://www.amazon.com/Advisors-Guide-Annuities-John-Olsen-ebook/dp/B008GVYB5U
- Index Annuities: A Suitable Approach, written with my friend and partner, Jack Marrion (Olsen & Marrion, LLC, 2010, www.indexannuitybook.com.)
- Taxation and Suitability of Annuities for the Professional Advisor, (Olsen & Marrion, LLC, 2012, www.indexannuitybook.com).
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