One of the more attractive features of an annuity is tax-deferred growth. As long as the money remains inside the annuity, the government won’t tax any of the earnings.

A deferred annuity has two phases, the accumulation phase and the distribution or payout phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. During the distribution phase, the annuity is paid out. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime.

Income taxes will be due on most annuity payments the annuitant receives, regardless of the payment method. If the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into that annuity and its value when it is paid back.

Taxes on a Lump-sum Distribution

As an example, let’s say you invested $100,000 over the years into an annuity that’s worth $300,000 when you retire. If you take a lump sum distribution, you will owe taxes on the gain of $200,000. Taxes on the gain will be taxed at ordinary income tax rates in the year of the distribution. Most critics of annuities will suggest that this is unfair, and makes annuities less attractive because distributions do not qualify for capital gains tax treatment. What they often fail to mention is the investments owned by annuities, such as mutual funds or CD-like investments, don’t receive much, if any, capital gains tax treatment to begin with.

Taxes on Annuitization

If you annuitize the distribution is place into two categories, one is considered as a return of principal (i.e., your investment) and the other as part of earnings. The annuitant will owe income taxes on the part of the payment that’s considered earnings. The amount of each payment that won’t be taxed is computed by establishing an exclusion ratio.  The exclusion ratio can be determined by dividing the investment in the contract by the total amount expected to receive during the payout period.

As an example, assume you have a fixed annuity in which you’ve invested $100,000 that will pay you a sum of $1,000 per month for life starting at retirement age 65. According to IRS life expectancy tables, you will receive those payments for 15.0 years, so your contract’s value is $180,000 (12 X $1,000 X 15.0). Your exclusion ratio is 55.5% ($100,000/$180,000). Therefore, out of the $12,000 the annuity pays each year, you may exclude $6,660 from income. The remaining $5,340 of that payment will be subject to ordinary income taxes.

Taxes on Variable Annuities

With a variable annuity, it is difficult to predict how much the annuity payment will be each month because the market value of the investment will change based upon the performance of the market. As a result, the excludable amount of each annuity payment is determined by dividing the investment by the period of time the annuity is expected to be received.

In the prior example, the annuity would payout for 180 months (12 X 15.0). If the annuity was a variable annuity, the amount to be excluded from the monthly payment would be $556 ($100,000/180). The remainder of each payment would be declared and taxed as income for that year.

What Happens If a Withdrawal is Made Without Annuitization

A withdrawal is any amount distributed from the annuity that is not part of an annuitization payment. Withdrawals are taxed based on when the annuity was purchased. Investments made after August 13, 1982, are taxed on a last-in, first-out basis. This means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the annuity. Also, withdrawals made prior to the annuitant’s age 59 1/2 are subject to a 10% early withdrawal penalty.

This material does not constitute tax, legal, or accounting advice, and neither AnnuityScene.com nor any of its agents, employees, or registered representatives are in the business of offering such advice. It cannot be used by any taxpayer for purposes of avoiding any IRS penalty. Anyone interested in these transactions or topics should seek advice based on individual circumstances from independent professional advisors.

A Tax-Sheltered Annuity is a type of retirement plan under section 403(b) of the Internal Revenue Code which permits employees of public educational organizations or tax-exempt organizations to make before tax contributions via a salary reduction agreement to a tax-sheltered retirement plan.  An individual may only obtain a 403(b) annuity under an employer’s TSA plan.

The contributions to the annuity are deducted from the employee’s income, and as a result, the contributions and related benefits are not taxed until the employee withdraws them from the plan.  Because the employer can also make direct contributions to the plan, the employee gains the benefit of having additional tax-free funds accruing.

There is usually a maximum amount an employee can contribute to the plan, however, sometimes there are “catch-up” provisions allowing employees to make additional contributions to make up for previous years where they did not make the maximum contribution.

Some of the benefits of this type of annuity are:

• Tax on the employee and employer contributions is deferred until withdrawal.
• Investment gains in the plan are not taxed until withdrawal.
• Retirement assets can be carried from one employer to another.
• Contributions can be made easily from payroll deduction.
• Flexible plan options are available.
• Saver’s credit may be available under certain conditions and guidelines.
• Better financial security at retirement.

An early withdrawal from the plan would result in taxes and possible penalties.  There is a maximum amount you can contribute annually.  If you contribute over the maximum amount, every dollar is taxed based on your current tax bracket.

Notwithstanding, the tax-sheltered annuity is a great retirement savings tool because taxes are deferred until you withdraw money from the plan.  Your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them.

What’s the difference between a fixed annuity and a variable annuity?  Generally speaking fixed annuities are considered to be more conservative.  Variable annuities, having the potential for gain and losses, have a higher risk.

Fixed Annuities

Fixed annuities are issued by insurance companies and its security is directly related to the financial strength and claims paying ability of the issuing carrier.  In a fixed annuity, the insurance company guarantees you will earn a minimum rate of interest during the time your account is growing.  Once the time period is over a new guarantee interest rate is set for the next period.  The insurance company also guarantees the periodic payments will be a guaranteed amount per dollar in your account.  These periodic payments may last for a definite period, such as 10 years, 20 years or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

Variable Annuities

Variable annuities typically offer a range of funding options from which you may choose.  These funding options may include portfolios comprised of stocks, bonds, mutual funds, and money market instruments.  The account value of variable annuities can go up or down based on market fluctuations.  Your purchase payments and earnings are not guaranteed; instead they depend on the performance of the underlying investment options.  If the funding options you choose for your annuity perform well, they may exceed fixed annuity returns  If they don’t perform well, you may lose not only any earnings you’ve made, but even some of your actual investment.

Some variable annuities offer, in addition to a range of funding options, a fixed account option that guarantees both principal and interest, much like a fixed annuity.  A fixed account option can give you the security of allocating some of your purchase payment more conservatively while still taking advantage of market potential.

Fixed and Variable Annuity Charges/Fees

If you withdraw money from an annuity, there may be a surrender fee or withdrawal charge.  Usually surrender charges are applied to all purchase payments you make and can reduce to zero over time.  If you save over a longer term, it is possible no surrender charges would apply.

Also, the insurance company will recoup expenses if you choose to surrender your contract early.  These are expenses the insurance company could not be realized because you did not leave your money on deposit long enough.  Many surrender charges start around 7% to 9% in the first year of a deposit, possibly going to 0% within 7 to 9 years, and may provide for a free corridor (e.g., 10% of the account value) where surrender charges do not apply.  Some annuities have surrender charges which are longer and higher than this and you should examine all features of the contract carefully.  In addition, a market value adjustment may apply that may be positive or negative.

Surrender fees are usually highest if you take out money in the first few years of an annuity contract.  Withdrawals and income payments from annuities are subject to ordinary income taxes.  Withdrawals and income payments before age 59 ½ may be subject to a 10% tax penalty (unless an exception applies).

Fixed annuity contract expenses are taken into consideration when the issuing company declares the periodic interest rate or determines the payment amount.

Variable annuities usually have more features and they have, therefore, more complex and higher fees than fixed annuities.  For example, variable annuity fees may include an annual contract charge (referred to as a “separate account” charge) which covers administrative expenses and a basic death benefit.  In addition, a variable annuity, like many other investments, has fees for the management and operating expenses of the funding options in which your money is invested.