Annuities offer several benefits when you begin receiving distributions. You receive guaranteed income that lasts for life, no matter how long you live. The insurance company takes on the risks of low investment returns and a long life. You don’t have to worry about scheduling distributions or deciding which assets to sell to raise cash. The regular checks show up on schedule. The certainty and risk transfer are why many people are taking a shine to annuities, especially immediate annuities.
The benefits are enhanced when you know the tax breaks annuities offer and how to maximize them on your income tax return. While the income distributed to you is taxed as ordinary income, all of each payment isn’t ordinary income to you. For most people, a large portion of the annuity distributions is tax free. Only a small portion of each distribution is taxed.
Let’s look at how to maximize the tax-free portion of each annuity payment. We’re talking about the tax treatment of monthly or other periodic payments from a commercial or nonqualified annuity. These are annuities that are not paid from qualified retirement plans, such as IRAs, 401(k)s, and employer defined benefit plans. Payments from qualified plans have different tax rules. Commercial annuities generally are those sold by insurance companies outside of qualified retirement plans.
Commercial annuities are taxed under what the IRS calls the General Rule. (Other annuities are taxed under the Simplified Method). The General Rule applies to contracts that have been annuitized. That means you have elected to take a series of payments made at regular intervals and that last for longer than one year. The most common election is for the payments to be received monthly and paid for life or the joint life of you and your spouse, known as a joint and survivor annuity. Other payment periods are available. If you do not receive regular, periodic payments, the tax rules are different than those discussed here.
Under the General Rule your investment in the contract (also called the basis) is returned tax free over the period the payments are received. Part of each payment is a return of your investment (or net cost) and part is a payment of taxable income.
First, determine your net cost or investment by adding the total premiums, contributions, and other amounts you paid into the contract. Only after-tax amounts are included. If a contribution was deductible or excluded from your income, it is not part of the net cost. Employer contributions to the annuity are included only if they were included in your gross income.
From this total subtract refunded premiums, rebates, dividends, and unpaid loans as of the annuity starting date. Also subtract any additional premiums paid for double indemnity or disability benefits and any tax-free amounts received before the annuity starting date. Other adjustments might be required if the annuity has death benefit features and refund features of the annuity. The standard immediate annuity isn’t going to have these features, but some of you might own annuities with one or more of them. Your insurer should be able to tell you if you have any of these amounts or features and how the basis needs to be adjusted.
The tax-free amount of each payment is the ratio between your investment in the contract and the total expected return. So your next step is to determine the expected return. This is the amount that you and any beneficiaries are expected to receive over the life of the contract.
When the payments are received over a fixed period of years, the expected return calculation is simple. If the payments are monthly, multiply the amount to be received each month by the number of months the payments are to be received. The result is your expected return.
When the annuity will make payments for life, the calculation is a bit different. The calculation also differs when the payments are for one person’s life, for two lives with the payment remaining the same after the first death, and for two lives with the payment changing after the first death.
We’ll start with the most common situation: an annuity that pays the same amount monthly over the lives of two people, usually a married couple. The expected return is computed based on the combined life expectancy. To find the life expectancy you go to IRS Publication 939 (free and available on the IRS web site or by calling 800-TAX-FORM).
First, you need to know your ages. The ages to use are your ages on the birthdays nearest the annuity starting date. That’s the date the regular payments began.
Most people will use Table VI in Publication 939. If you didn’t make contributions to the annuity after June 30, 1986, then you would use Table II. In the table you’ll find a factor that is based on your two ages. Multiply the annual payment by the factor in the table. The result is your expected return. If payments are made quarterly, semiannually, or annually instead of monthly you’ll need to make adjustments using instructions in the publication.
After computing the expected return, divide the investment in the contract by the expected return. The result is your exclusion percentage. This is the percentage of each payment that is excluded from gross income. You multiply this percentage by the amount of each payment and exclude the result from income on your tax return. You do this until the total exclusions over the years equal your investment in the contract. After that, the entirety of each payment is included in gross income.
Example. Max Profits is 70 as the annuity starting date nears, and his wife Rosie is 67. The annuity in which Max has an investment of $50,000 will pay $500 monthly over the lives of both Max and Rosie. The factor from the table is 22.0. The annual payment is $6,000. The annual payment is multiplied by 22, for an expected return of $132,000. Max divides the $50,000 investment by $132,000 to determine an exclusion ratio of 37.88%. From each $500 payment, Max and Rosie exclude $189.40 until the have recovered Max’s $50,000 investment, which will take 264 months or 22 years.
When the annuity is paid for the life of only one person, Table V from IRS Publication 939 is used. The rest of the calculation is the same as before.
Example. Max Profits is 66 at his birthday nearest the annuity starting date and will receive $500 monthly from an annuity in which his investment is $50,000. His annual payment will be $6,000. The factor from Table V for his age is 19.2. The expected return for Max is $115,200. Max divides $50,000 by $115,200 to determine an exclusion ratio of 43.4%. From each $500 monthly payment, Max excludes 43.4%, or $217.01. The exclusion continues until Max recovers his investment, which will take 230 months or 19.2 years.
The calculation has more steps if the payment continues after the owner’s death but the amount declines. There also are other payment schedules possible, and the methods for calculating their expected returns are discussed in IRS Publication 939.
If you and any beneficiary die before the full investment is recovered, any unrecovered investment is a loss that qualifies as a miscellaneous itemized deduction on the final tax return of the last payee.
The insurer making the annuity payouts is required to withhold income taxes from each payment unless you request zero withholding. You also can request higher withholding. As we have discussed in past visits, having taxes withheld might save you the burden of computing and paying estimated taxes each quarter and make it easier to avoid penalties for underpayment of estimated taxes. Consider estimating your total income taxes for the coming year and requesting this amount be withheld from the year’s annuity payouts.