There are two types of money you can fund an annuity with: Taxed & Taxed Deferred. Better known as, “Qualified” (i.e., 401k, 403b, IRA, SEP-IRA, etc.) & “Non-Qualified” (Cash, Brokerage Accounts, ROTH IRAs, etc.) money.
And there are two overarching categories of annuities: Deferred & Immediate.
Which type of annuity you choose, and what type of money you use to fund it, will determine how your annuity will be taxed.
Let’s start with the basics:
Qualified Money (money you have not paid taxes on):
No matter what type of product you fund – whether it’s an annuity, a CD, mutual funds, stocks, or bonds – if you fund it with Qualified Money, it will be taxed at normal income when you withdraw any of it. And if you do not need the money for income, the IRS will help you out and force you to start withdrawing at the age of 72. This is known as an RMD, or “Required Minimum Distribution.”
Of course, there are savvy ways to get around this with Charitable Remainder Trust and things like that, but usually those are expensive to set up and not practical for the average American with a normal retirement account, such as an IRA. Eventually, Uncle Sam is going to get his cut.
One strategy you can consider when you find yourself in this situation is the “Atlas RMD Rescue Plan.” This does not help you avoid taxes, but it could give you a strategy to prevent being forced to take money out of an account that has lost money due to a market downturn. You can view that strategy by clicking here.
Non-Qualified Money (money that has already been taxed):
When you transfer Non-Qualified money into an annuity, that principal amount is known as the “cost basis.” Any growth on that principal amount now becomes taxable. But, it depends on the type of annuity that will determine how much in taxes you will pay.
Deferred Annuities Designed for Growth Only:
Let’s say you put your Non-Qualified money into a MYGA (Fixed Interest Annuity) or Fixed Indexed Annuity. Both are designed for growth and may or may not be used for income in the future.
If you choose to never withdraw any of the money from these annuities, the taxes can be deferred forever. However, the beneficiary of this money will pay taxes on it, but they will have options on how, and in what timeframe, to pay them. This could be a good option for someone looking to leave money to their children and does not want the fees and risk associated with traditional investments.
If you choose to withdraw some, or all the money, the growth portion will be taxed first as normal income. This is known as “LIFO”, Last-in First-Out. Or earnings first withdrawal.
But, what if you choose to take only a portion of that money and turn it into an income?
Let’s say your cost basis is $100,000 and it has grown to $200,000. If you wanted to take $100,000 and turn it into a guaranteed income, $50,000 would be recognized as your cost basis, and $50,000 would be recognized as taxable.
Deferred & Immediate Annuities Designed for Income:
Now, let’s say you choose to put the money in an Income Annuity. You would fall into something called an “exclusion ratio.” Meaning, only a portion of the income would be taxed because the IRS views part of the income as a “return of premium.”
Here’s how that works (this is just an example, so don’t hold me to these numbers):
Let’s say a 65-year-old male transfers $100,000 to an Income Annuity and starts the income immediately. That annuity is set to pay him $6,500 per year guaranteed for the rest of his life. The IRS Uniform Lifetime Table sets his life expectancy at 21.9 years.
Here’s how to figure out what portion would be taxable:
$6,500 x 21.9 = $142,350
$100,000 (cost basis) / $142,350 = 70.25% (exclusion ratio)
$6,500 * 70.25% = $4,566 (is excluded from being taxed)
$6,500 – $4,566 = $1,934 (is the annual taxable amount, or $387 if you’re in a 20% bracket)
If the annuitant lives beyond 21.9 years, or beyond 87 years old, he will still receive the $6,500 and will pay tax on the entire amount.
And it works the exact same way for a deferred income annuity, but the lifetime expectancy would be shorter because you would be older at the time of income activation.
This is a pretty boring subject, and I appreciate you sticking with it. Overall, the tax treatment of income from an annuity is an important factor that should be taken into account when considering product options to support a retirement income plan. And you should always check with a professional tax preparer as Atlas Annuity Strategies, Inc. does not give tax advice. This article is meant for educational purposes only.
If you would like to learn how to use annuities to achieve a guaranteed lifetime income, then I highly recommend checking out my “20% More Income in Retirement” video series. You should also check out our “Video” page to watch all our great educational material to learn the most you can about annuities. Especially our latest release, the “Atlas RMD Rescue Plan” to learn how annuities can help you maximize the outcome of your RMDs. Then take a step to secure your retirement and click the “Schedule a Call” button to view my calendar and get all your questions and concerns answered.
I may not be publishing anything next week, so let me take this opportunity to wish all of you a very Happy Thanksgiving!
All the best,