As more baby boomers consider fixed annuities to protect retirement income, the issue of taxation of annuity income becomes an important factor. Because immediate annuity strategies are something we will be studying for our retirement, I thought now would be a good time to look at the tax issues.
Taxation of Immediate Fixed Annuities
The first question to be asked to determine how annuity income will be taxed is: Where is the premium money coming from? If you are purchasing a fixed annuity using money inside a 401(k) or other tax deferred retirement account, then every dollar that the annuity pays out to you will be taxed as ordinary income. Very simple and potentially quite financially painful!
In the more likely event that you use after-tax dollars to purchase the annuity, the taxation rules become somewhat similar to what happens with taxation of the cash value in whole life insurance. The basic rule for both is that money that is paid out as a return of premium is not taxed. Earnings that exceed the premium paid are taxed as ordinary income.
In the case of a fixed annuity that pays you monthly or yearly over your lifetime, it gets a little more complicated. Unlike cashing in a whole life policy, you are not receiving the money all at once. Accordingly, the IRS imposes taxes on the periodic annuity payouts based on your life expectancy at the time that the annuity payments begin.
For example, assume that you are 60 years old when you decide to purchase a fixed immediate annuity. You purchase the annuity for a payment of $100,000. The annuity contract promises you lifetime annual payments of $8000. According to government actuarial life expectancy tables, you have an additional life expectancy of approximately 20 years. So, to determine how much of your annuity income is taxed, the IRS will divide the $100,000 premium by 20, giving you an annual return of premium payout of $5,000. This will not be taxed. (Again, this assumes that you paid the premium with after-tax dollars.) The remaining $3,000 in annual payout ($8,000-$5,000=$3,000) is considered income, and will be taxed at ordinary income tax rates.
Note that if you outlive your life expectancy, then 100% of the annuity income from that point forward becomes taxable. Living longer is not a bad thing for your annuity payout and return on investment if you are financially prepared for the increased taxation.
Now we will wait and see if the government changes the rules!
Photo credit: Amit Gupta