Getting the most value from any annuity arrangement begins with an understanding of the relevant income tax rules. This helps us to understand how much income taxes will be taken from our annuity payments during retirement. This article will discuss some important tax ruled you need to be aware of with respect to annuities. The income tax ruled that apply to all annuity payments start with Section 72(b) of the Internal Revenue Code (“Code”). This rule begins with the idea that every person should be allowed to recover his or her own contributions to a non-qualified annuity free of tax. This makes perfect sense, as your own non-qualified contributions were paid for with the after-tax money. Your personal investment in a non-qualified annuity is commonly referred to as your cost basis. The Code allows you to recover your cost basis gradually over the time you are receiving annuity payments. So, out of each payment received by you, a portion will represent a tax-free return of your basis. The amount of the payment that exceeds the basis portion is subject to federal income taxes at your respective tax rate. This will range anywhere from 10 to 39.6%, depending on your income level during your retirement years. To understand how this works, let’s look at an example. First, let’s assume that our annuity owner, who is a non-smoking 60-year-old male in good health, invests $250,000 of his own funds into a fixed deferred annuity that will start making income payments to him for the rest of his life when he turns 65. Let’s assume that this taxpayer will pay income taxes at a 15% marginal rate when he retires. Let’s also assume that the monthly annuity payments in our example come to $1,734 when the annuity owner starts taking payments. (principal and interest for life). Now we have enough information to determine the federal income tax on the annuity. Looking at the life expectancy tables published by the Internal Revenue Service, we would see that the life expectancy established by these tables for a 65-year old male is 85 years of age. Based upon the initial investment, annuity payment, and life expectancy, the annuity owner will be allowed to exclude $1,040 (60%) of each annuity payment from the income taxation. Once we apply the 15% rate to the remaining portion of the payment, we could come up with a federal income tax $104 for each annuity payment. Here’s a breakdown of how the excluded part of the annuity payment was calculated.
Investment in Contract ($250,000)
____________________________________________ x Payment ($1,734) = $1,040 Excluded Amount
Expected Payment over Life ($1,743 x 12mo x 20 yr)In the event of an unfortunate death prior to the life expectancy, the tax code still allows you to recover your unused cost basis by taking this as a deduction on the final tax return. For example, if we assume in our previous example that something happened to the annuity owner in the fifteenth year, he would be entitled to a $62,400 deduction on the final return. On the other hand, if annuity payments are received after the life expectancy period, then the entire amount of these payments are subject to taxes. Like all annuity guarantees, annuity payments are subject to the claims-paying ability of the issuing company. The payment assumptions were taken from a hypothetical annuity illustration of a healthy male who is eligible for preferred underwriting rates. Your results could vary based, among other things, upon your age, income and tax rate status, contribution, annuity payment beginning date, health and tobacco-user status. Please also note that tax laws are subject to frequent changes. You should therefore consult with your tax advisor regarding your individual circumstances.