Today we're going to be talking about a detailed explanation how annuities are taxed.
Now, annuities have become increasingly popular over the last decade. According to a Retirement Institutional Poll, principle protection and guaranteed lifetime income were not the leading reasons why individuals purchased an annuity, to begin with. The information presented here is NOT tax advice. Please reach out to a tax professional before you make a decision.
In fact, the leading reason was the idea of tax deferral, which allows you to postpone income taxation until that distribution phase in retirement.
Now, while that feature is great, there can be questions among how an annuity is taxed.
Today it's my goal as to educate you on the different types of tax classifications, inheritance options, and going back to the basics.
Let's go over to the board here and let's actually talk about the basic policy structure.
There are three parties to an annuity contract. There's your contract owner, annuitant and beneficiary.
Now, your owner is the one who purchases the contract, purchases the rights to the contract, can account for and name the annuitant and beneficiary and at the same time, they're responsible for any income taxation.
A lot of times the owner is the annuitant and whenever it's not, the owner is still responsible for that income taxation.
The annuitant, on the other hand, is the "measuring stick" for the insurance carrier to determine how that payment is going to be calculated.
Given his or her sex and date of birth, they'll be able to tell how much the owner is able to receive an income.
The beneficiary is the one when all is said and done is able to continue on those payments after the death of contract owner or they're able to make a couple of different other moves when using that money.
Additional basic structure here, there's two different phases to an annuity contract.
There is your accumulation phase when you fund in pre or post tax dollars, that's going to defer until we reach a pre determined age, that next phase is the distribution. There are a lot of different ways you can distribute funds, whether that's withdrawals, annuitized or activating an income rider of which we'll get into later on.
Let's move our way over into the different tax classifications of an annuity. Now, while annuities come in many different shapes or forms, there's a clear distinction in how they're separated.
Qualified or non-qualified. Are they funded with pre-tax dollars or after-tax dollars? And guess what? They're treated 100% differently when in form of taxation.
If we look at the qualified accounts, your 401(k)s, 403(b)s, profit sharing plans, any income distribution, whether in the form of withdrawal, annuitization or income rider is 100% taxable at their ordinary income rates given what rate you're in currently today.
The non-qualified consists of after-tax funds. So, your savings, brokerage accounts, CDs and this is a little bit different. Not all of that is taxable. Well, I should correct myself. When you take out a withdrawal, we've all heard of that LIFO option where you're last in first out.
When we take a withdrawal and the income rider, the earnings are always coming out first. IRS is going to get their money first and then after we exhausted our earnings inside of the contract, then it's going to be our cost basis, the premium that we put into the policy which will be tax-free.
Once we're in the insurance carriers pocket, this is where it gets great. We're in the insurance carriers pocket, but at the same time 100% of those payments would be taxable as ordinary income.
Now, I did want to mention premature distribution penalty. Of course, whether you're qualified or non-qualified, we still have to abide by this tax-deferred treatment and if we take out funds before 59 1/2 years of age, we'll be slapped on the wrist by the IRS with a 10% penalty.
There are exceptions to that. Whether the contract owner died before that age, whether he became disabled after the contract was purchased, whether it's a first-time home buyer, medical expenses or their annuitizing.
There are a couple of different exceptions to this, but just know that there is a 10% penalty on any distribution prior to age 59 1/2.
Let's get back to one of the more interesting parts, and that's the exclusion ratio.
If we choose to annuitize our contract, we're going to be hit with the exclusion ratio, which means the payment that we receive is going to be split accordingly as tax-free and as taxable.
Now, how do they make that assumption? How are they able to determine how much is composed of each?
As an example, let's take a 70-year-old. He has $100,000 that he wants to give the insurance carrier. That insurance carrier is going to determine based on the mortality table he has 15 years of life left to live. So we'll give him $10,000 a year for that amount of time.
If we add that up, that's about a projected return of $150,000. So, what happens is that they take the basis, the $100,000. premium and they divide that by the projected return?
What that's going to do is give them a percentage of how much money is going to be excluded from those payments or in other words, how much of that payment is going to be tax-free. In this case, 66% of that payment is tax-free, which is the return of premium, and then 34% of that is going to be taxable.
Hopefully this gives you a just a little rough understanding of how exclusion ratios work along with how these different accounts are taxed.
Let's move over and to the third part where Benjamin Franklin said it best, "Two things are certain in this world, death and taxation."
What we saw earlier is that when that contract owner dies, that beneficiary is left with a tax bill.
The beneficiary has a couple of different options on how fast they want to pay that tax, and the IRS allows them to select and choose that option at that time. It's really split into two different categories. Is that beneficiary a spouse or is it a non-spouse?
There's a distinction between the two and there's different options for each one. If we look at the first one, non-spousal options, if that person inherits an annuity, they can choose to take a lump sum option.
Now of course, this is going to create the biggest tax liability because they'll take out and pay taxes on the earnings, not the basis, but still it's going to create a tax liability for that individual.
There's the five-year role, which allows them to spread out that liability over five years. In fact, they can wait until the fifth year and take a lump sum option as well.
Then there's the annuitization, for that individual, which is the most efficient way from a tax liability standpoint, is to annuitize those payments over his or her life expectancy and create that stream for themselves.
They have 60 days to do this after the death of the contract owner to know. On the spousal side, they have the same options, but they also have two more. They're able to continue the contract altogether that their initial contract owners set up. That's great.
It's the most popular option because they don't have to report any taxation right now and they can continue to kick that can down the road in the future in the form of taxation. And then they also can rollover to an IRA if that amount is qualified, get it out completely and do what you want with that.
Today we walked through the basics. We talked about the different types and classifications of annuities, how they're treated. We talked about some inheritance options and I hope you learned alot!