Annuity Taxation

Annuity taxation is a complicated process. One feature of annuities that so many people focus on is the tax deferment feature. But even tax deferments can have its drawbacks in certain situations. The only way to make annuity investments suitable for your financial goals is to learn about how annuities work and the tax implications of certain types of annuities. Tax benefits alone should not be the only reason you invest in an annuity. This is especially true because annuity taxation has its drawbacks as well.

Advantages vs. Disadvantages of Annuity Taxation

Taxes are an important part of any annuity. For many people tax deferments is one of the most appealing aspects of many annuities. Although deposits made to fund an annuity are not tax-deductible, the earning in an annuity can be tax deferred. In this scenario, the money continues to grow and the annuitant (annuity owner) doesn’t have to pay taxes on the earnings. The tax liability is deferred to a later date. Once the annuity starts paying the annuitant distributions, usually after age 59 ½, then the annuitant pay taxes.

The main tax disadvantage for annuities occurs when you withdraw money early. If an annuitant needs money for an emergency, the IRS penalized the owner heavily for removing the funds. The IRS levies a 10 percent penalty. In addition, the annuitant has to pay taxes on the withdrawn funds.

The disadvantage can continue. In some cases gift taxes or estate taxes apply. This happens after the death of the annuitant when his heirs received the remainder of the funds in the annuity. If the annuity is not set up properly, the annuitant’s heirs may face a huge tax bill. For best results in dealing with taxes and annuities, a tax attorney can provide the most up-to-date tax information.

Taxation at death  

After an annuitant’s death, the money in the annuity is handled in a variety of ways depending on the type of annuity and policies of the financial institution that set up the annuity. In some cases, the company places the death benefit into the annuity and the spouse then receives the regular distributions. This is called spousal continuation. Essentially, the spouse takes over as owner of the annuity with no tax implication. Other financial institutions have the spouse choose between the death benefit and spousal continuation. Spousal continuation is viewed more favorably for tax purposes. The annuity is not considered a part of the estate and so avoids estate taxes.

Another tax issue occurs when the annuitant dies and names a non-spouse as the beneficiary of the annuity. With a beneficiary in place, the annuity is not included in probate. But the tax deferred income in the annuity passes on to the beneficiary. The beneficiary pays taxes on the distribution at his normal tax rate whether the he elects to receive a lump sum or periodic payments.

Tax-free annuity exchanges (1035)

Another tax advantage for annuities is the Section 1035 Exchange. This refers to the IRS Code section 1035  (Link to IRS page). This section allows an annuitant to transfer the accumulated money in an existing annuity to a new annuity set up by a different financial institution without having to pay taxes on the money. The 1035 exchange was set up to help annuity owners exchange outdated annuities for newer contract that reflect their current circumstances while at the same time maintaining the tax benefits. This tax-free exchange or transfer doesn’t create a taxable income for the annuitant. To take advantage of Section 1035 Exchange, the annuitant also has to meet all the other IRS requirements as well.

When investing in annuities, it is important to learn about all the tax advantages and disadvantages of such an investment. Seeing only the tax-deferment benefits may blind you to other tax consequences that may cause a higher tax liability for the annuitant or for his heirs.