Annuities are popular, varied – and complicated when it comes to taxes
Determining tax treatment for annuities doesn’t have to be a mystery. Here’s a guide.
More than 2,000 years ago, in ancient Rome, many forward-thinking citizens wanted to plan for their financial future. The financial advisors of their day were glad to oblige, selling financial instruments called annua, or annual payments.
This concept had staying power, because annuities are still popular today.
Annuities can satisfy a variety of needs for individuals who want regular cash flow. For example:
- A healthy individual may invest in an annuity instead of purchasing long-term care or disability insurance in case he is impaired and can’t work.
- A self-employed professional with volatile cash flow may consider purchasing an annuity to add stability to her cash flow.
- Or, an individual planning for retirement might purchase an annuity because its regular cash flow can replicate a pension or supplement his Social Security benefits.
Whether purchasing an annuity is the best solution in a taxpayer’s particular situation depends on many factors, many of which are beyond the scope of this article. Because annuities are so complex (sales and surrender charges, cash value buildup, and a plethora of features and options), they may be overwhelming to many people. But, depending on an individual’s situation, certain features in an annuity may make them beneficial to an investor.
In this article, we’ll examine how different types of annuities are taxed, and provide a practical guide for taxpayers and tax professionals.
The tax story gets complicated
Annuities are taxed depending on their type and attributes, including whether:
- The annuity is qualified or nonqualified. Individuals acquire qualified annuities through a qualified retirement plan, such as a 401(k), 403(b), defined benefit plan, etc. Employers can also purchase qualified annuities for employees under a qualified plan. Individuals purchase nonqualified annuities with after-tax funds, usually from an insurance company, broker, or other financial institution, or through an employer.
- Payments are periodic or nonperiodic. Individuals can receive regular, periodic payments (monthly, quarterly, etc.), or nonperiodic payments, such as a discretionary withdrawal.
- Payments are immediate or deferred. Taxpayers can start their annuities right away or in the future.
- Any portion of an annuity payment represents the taxpayer’s basis. This is referred to as “investment in the contract.”
- The annuity is fixed or variable. Annuities offer income for a guaranteed (fixed) period, or for the life of the owner of the annuity. Owners can also purchase survivor options to allow a beneficiary, such as a surviving spouse, to continue receiving payments until his or her death.
Two methods for determining the tax on an annuity
One of the key variables in determining how an annuity is taxed is whether it is a qualified annuity. Periodic distributions from qualified annuities generally* follow the Simplified Method – not to be confused with “simple” – for determining their tax treatment. Distributions from nonqualified annuities use the General Rule.
The Simplified Method for qualified annuities
Under the Simplified Method, each annuity payment generally consists of a nontaxable component (basis) and a taxable component (annuity earnings). The tax-free part of each annuity payment is calculated by dividing the taxpayer’s cost (investment in the contract) by the total number of expected monthly payments, based on IRS tables that project the taxpayer’s expected life span.
If the taxpayer didn’t purchase the annuity or doesn’t have any investment in the contract, the full payment amount is taxable.
Example of an annuity distribution using the Simplified Method
In 2015, Matt, age 62, received $1,500 per month ($18,000 for the year) from an annuity that started July 10, 2013. On that date, Matt’s investment in the contract (basis) was $40,000.
Matt determines the nontaxable portion by dividing his basis ($40,000) by the total number of anticipated annuity payments (260), found in IRS Publication 575, Pension and Annuity Income.
Matt calculates the excludable amount of each payment as $40,000 / 260, or $153.85. That leaves Matt a taxable portion of $1,346.15 from each month’s annuity payment of $1,500, after he excludes $153.85. For the year, Matt owes tax on $16,153.80. On his Form 1040, Matt will enter $18,000 on line 16a, Pension and Annuities, and he will enter $16,154 on line 16b (Taxable Amount).
The Form 1099-R Matt receives from the annuity payer should also show this information: $18,000 in box 1 (Gross Distribution) and $16,153.80 in box 2a (Taxable amount). However, if box 2b (Taxable amount not determined) is checked on the form, Matt will need to complete this calculation using the IRS publication to avoid being taxed on the full amount.
The General Rule for nonqualified annuities
If taxpayers receive periodic payments under a nonqualified annuity, their payments are taxed using the General Rule. Under this method, the tax-free portion of each payment is based on the ratio of the taxpayer’s investment in the contract (basis) to the annuity’s total expected return (the amount of each annuity payment times the number of annuity payments in the contract).
Example of an annuity distribution using the General Rule
Jason purchased an annuity 5 years ago from Protection Insurance Group (PIG). He will receive $300 each month for 10 years ($3,600 per year). Under the terms of his annuity, if he dies before the end of that 10-year period, the undistributed portion of the annuity will be lost. Jason was 68 at the annuity starting date, when his investment in the contract (basis) was $15,000.
His expected return is $32,760, calculated as his annual payment of $3,600 times 9.1, the factor shown in IRS Publication 939, General Rule for Pensions and Annuities, Table VIII, for a 10-year annuity when the owner is 68.
At the annuity’s starting date, Jason’s basis was $15,000, so the amount he can exclude is $15,000 / $32,760, or 45.8 percent of each payment ($1,649). For 2015, Jason enters $3,600 on line 16a of Form 1040 and $1,951 on line 16b ($3,600 – $1,649).
PIG should distribute Form 1099-R to Jason showing the annual annuity payments, as well as the taxable portion.
Calculating the taxable portion of the nonqualified annuity is straightforward in concept: Just divide the taxpayer’s basis by the annuity’s total expected return. But arriving at a taxpayer’s “investment in the contract” and “total expected return” is often itself a product of many factors. Unfortunately, these factors – or even the taxpayer’s total basis – may not be shown on the Form 1099-R sent by the payer.
The investment in the contract is the sum of total premiums, contributions, and other amounts the taxpayer paid, reduced by any refunded premiums, rebates, dividends, or unpaid loans that the taxpayer received before the annuity starting date that weren’t previously taxed.
This net amount may have even more adjustments. For example, some annuities have a refund feature, which allows the value of the annuity to be refunded to beneficiaries or an estate if the annuity owner dies before the annuity expires.
The after-tax return is also affected by various factors. One example is the net investment income surtax, which can be triggered for some nonqualified annuity owners.
The big picture
When deciding whether to invest in an annuity, individuals need to weigh the variety of features available in annuities and how they affect the annuity cost (investment). Investors should also consider how future annuity payments will be taxed, which affects the after-tax return on the investment.
Here’s a flowchart that will help determine how a particular annuity is taxed.
While ancient Romans may not have had to wrestle with the complexities of our tax code, their annuities were simpler than the modern variety. Fortunately, modern-day investors can take advantage of financial advisors to help with the investment decision, and tax advisors to help with the complexities of tax accounting and reporting.
The investor who purchases an annuity without professional advice is throwing himself to the lions.
* The Simplified Method is generally used to determine the taxable portion of annuity payments from qualified annuities. However, a taxpayer must use the General Rule for a qualified annuity, if (1) the taxpayer was at least age 75 on the annuity starting date, and (2) there are five or more years of guaranteed payments.