WHAT ARE ANNUITIES USED FOR?
While Annuities have a variety of uses and purposes, typically an annuity is used as a tax-deferred investment vehicle. Annuities may also be used as an immediate source of income for a specific number of years. In addition, annuities are commonly used to mitigate the risks associated with outliving your savings, referred to as longevity risks. There is also a wide array of riders that provide different forms of death benefits payable to the beneficiaries after the owner/annuitant’s death.
WHAT IS AN ANNUITY?
An annuity is an investment contract between an investor and a life insurance company that provides payments to the investor at a specified time in the future. It is important to note that Annuities qualify for preferential tax treatment allowing the interest earned to accumulate tax-deferred.
WHAT IS THE DIFFERENCE BETWEEN A FIXED ANNUITY AND A FIXED INDEX ANNUITY?
The primary difference is that the fixed indexed annuity provides the investor with the option to invest funds at an interest rate that is tied to market performance. The investor also has the options of investing the funds at a fixed interest rate that is declared at the beginning of each year. A fixed annuity generally has higher guaranteed interest than a fixed indexed annuity, but does not provide the options to invest at a potentially higher indexed rate.
WHAT IS THE DIFFERENCE BETWEEN AN IMMEDIATE ANNUITY AND A DEFERRED ANNUITY?
The most significant difference is that an immediate annuity begins to provide payments to the investor within 12 months of purchasing the annuity. A Deferred annuity on the other hand has two distinct phases. The first is the accumulation phase during which the money put into the annuity earns interest and accumulates. The second phase, the payout period is the period of time during which the insurance company pays an income to the selected annuitant.
HOW ARE ANNUITIES TAXED?
All earnings in an annuity contract grow tax deferred. The distributions of these proceeds are taxed in two different ways depending on how payment was received and how the annuity was paid for. All proceeds from Annuities paid for with before tax income will be taxed as income. Where as with Annuities that are paid for with After-tax income are only subject to tax on the interest earned. In the case of a Non-qualified annuity the interest earned is taxed as income. There are also variations in how the proceeds are taxed depending on whether or not the income is in the form of annuity payments or in the form of withdrawals or surrenders. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
HOW IS AN ANNUITY DISTRIBUTION THAT IS CLASSIFIED AS AN 'AMOUNT RECEIVED AS AN ANNUITY' TAXED?
Payments that are paid out on or after the “annuity starting date” are generally treated as “amount received as an annuity”, payments if they are paid at regular intervals and are paid for a period lasting longer than a year. Non qualified annuities typically provide distributions that are partly tax-free. What is referred to as an ‘exclusion ratio’ in an immediate fixed annuity, a portion of each payment is tax-free. However with a variable annuity a pre-set dollar amount, call the ‘excluded amount’ is allotted as tax-free. Both the ‘excluded amount’ and the ‘excluded ratio’ are based on the total amount of payments expected to be paid as of the annuity start date. Once the owner has recovered all of the originally contribution, the additional payments will be taxed as income. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
HOW ARE DISTRIBUTIONS THAT ARE NOT CLASSIFIED AS AN 'AMOUNT RECEIVED AS AN ANNUITY' TAXED?
There are other forms of distributions such as withdrawals, dividends, partial surrenders etc. The tax treatment of these distributions is dependent on the extent of the gains in the contract, the date of the contract was purchased and the date the premiums are paid. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
WHAT IS THE 10% FEDERAL PENALTY TAX?
A 10 % penalty tax on the taxable amount of ‘early’ distributions is imposed by the Internal Revenue Code §72(q)(1) to discourage the use of annuities as a short-term tax shelter. This penalty is in addition to the state and federal tax the owner may have already paid on the distribution. If the distributions take place after the owner’s age of 59½, at death, upon disability, as annuitized distributions or are from an immediate life annuity then the 10 % penalty tax does not apply. If you are buying an immediate annuity with non-qualified money then the guideline of age 59½ does not apply. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
CAN A CORPORATION OR OTHER BUSINESS OWN ANNUITIES?
Yes, but an annuity contract owned by a non-natural person is taxed differently than an individually owned annuity. When a corporation or business owns an annuity all income from the annuity is taxed as ordinary income in the year it is received. The exception to the rule is when the non-natural persons is a trust and the trust’s beneficiaries are natural persons. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
ARE THERE ANY SPECIAL DISTRIBUTION REQUIREMENTS WHEN AN ANNUITY OWNER DIES?
Yes, there is a limit on perpetual tax deferral through successive ownership. To prevent this scenario the Internal Revenue Code imposes requirements on distributions after the death of a non-qualified contract owner by limiting the period that the income can be deferred for. These requirements depend on whether the annuitant died before or after the annuity starting date. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
MAY BENEFICIARIES ‘STRETCH’ DEATH BENEFITS?
Yes, beneficiaries of a qualified annuity may be able to maintain the annuity and take the minimum required distributions provided by the IRS; this practice is called a ‘stretch’. The options the beneficiary will have are dictated by a combination of tax law and policy specific stipulation. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.
CAN AN ANNUITY BE EXCHANGED TAX-FREE FOR A LIFE INSURANCE POLICY?
No, according to the Internal Revenue Code §1035 annuities can not be exchanged tax free for a life insurance policy. However, annuity to annuity exchange can be done tax free as well as a 1035 exchange from a life insurance policy into an annuity. *This is for information purposes only and is not to be taken as tax advice. Please consult a tax professional.