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Taxes and Annuities

The most desirable feature, to most people, about an annuity is tax-deferred growth. As long as the money remains in the annuity, the earning will not be taxed. This allows you to compound money, tax-free, but eventually the money will be taxed.

If you purchase a deferred annuity, there will be two phases: the accumulation phase and the distribution phase. In the accumulation phase, the annuity grows, tax-free, through the years as the investment compounds. During the distribution phase, the annuity is paid out. You can elect to receive a lump sum payout ot a series of scheduled payments over a specified period or a lifetime. If you choose to receive payments, the annuity is said to be “annuitized” and you are an “annuitant.”

However you choose to receive your money, you will be required to pay income taxes on every annuity payment. If you choose a lump sum, you will have to pay taxes on the growth of the annuity (meaning, subtract the money you put into the annuity from its worth and pay taxes on the gains).

Lump-sum Taxes

For example, say you invested $50,000 in an annuity and over the years your annuity’s value has grown to $150,000. Now you are 62 and you want to receive a lump sum payout. You will have to pay income taxes on $100,000 – that money which you gained from the investment.

The upside is that you do not have to pay taxes on the $50,000 investment. The downside is that the government taxes annuity gains as “ordinary income,” meaning you do not receive any capital gains tax breaks – you pay taxes based on the ordinary income tax rates the year of disbursement.

Taxes on Scheduled Payments

If you annuitize (choose scheduled payments), you will still be taxed on only the gains of your investment. This is calculated by determining an “exclusion ratio.” This is established by dividing your initial investment by the total amount you expect to receive during the payout period. (for more information, refer to the Annuities Glossary)

Taxes on Variable Annuities

Variable annuities are taxed a bit differently because you do not know much the annuity payment will be every month. The market value of your investment will change based on the state of the market therefore the amount excluded is calculated another way. For variable annuity tax exclusions you would divide your investment by the period over which you expect to receive payouts (in months). Using the above example you would divide $50,000 by the number of months you expect to receive payouts and the resulting number would be the monthly amount excluded from taxation.

Taxes and Beneficiaries

If you die before you receive any payments form your annuity, the money will be distributed to the beneficiary(s) you have listed on your contract. When they receive the payment, they will be taxed on the annuity’s earnings as ordinary income tax.
If you annuitize your investment before you die a few things could happen. If you chose a life only annuity, at your death nothing passed to beneficiaries and no taxes are due. If you chose a term-certain settlement option and die before that period is complete, your beneficiary(s) will receive the payments and will pay ordinary income on all earnings previously unpaid. On a joint-life annuity, the “joint” person, usually a spouse, will continue to receive an income tax exclusion on part of the annuity payments until the investment is paid out.


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