How to Maximize the Tax-Free Portion of Each Annuity Payment

The popularity of fixed and immediate annuities is climbing for those in or near retirement. It is not surprising. An immediate annuity offers fixed, guaranteed payments. The payments can last for life if you want, and even for the joint life of you and a beneficiary. In today’s volatile and uncertain markets, annuities add a level of certainty many people want.

Once you have purchased an annuity and payments have started, be sure you report them properly on your tax return. In most cases, a portion of each payment is tax free. Know the rules and maximize the tax-free portion of each annuity payment.

In this visit we will discuss 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 is called the General Rule. It applies to contracts that have been annuitized. That means you have elected to take a series of regular payments 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. But there are other payment periods 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 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.

Your net cost or investment is determined by first 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 for death benefit features and refund features of the annuity.

Next, you determine the expected return, which is the total amount you are expected to receive under the contract. For this calculation, use your age closest to the annuity starting date. The calculation of the expected return depends on the type of annuity payout. We will review the treatment of some of the more popular payouts.

Fixed period annuity. This annuity makes payments for a fixed number of years. When the payments are monthly, multiply the monthly payment amount by the fixed number of months for which payments are to be made.

Single life annuity. These are fixed payments for your life. Multiply the annual payment by a multiple representing your life expectancy from IRS tables. Use the multiple from either Table I or Table V from IRS Publication 939. You need to adjust the multiple if payments are other than monthly.

Example. Max Profits is 66 at his birthday nearest the annuity starting date and will receive $500 monthly. His annual payment will be $6,000. This is multiplied by the factor from Table V, which is 19.2. The expected return for Max is $115,200.

Joint and survivor annuity. If the periodic payment will not change after the owner’s death, the expected return is based on the joint life expectancy. The calculation is the same as for the single life annuity except Table II or Table VI is used to determine life expectancy.

Example. Max Profits is 70 at the annuity starting date nears, and his wife Rosie is 67. The annuity 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. This is multiplied by 22, for an expected return of $132,000.

The calculation has more steps if the payment declines after the owner’s death. There also are other payment schedules possible, and the methods for calculating their expected returns are discussed in IRS Publication 939.

Now, you can calculate the taxable and tax-free portions of the annuity payments.

First, determine your investment in the contract. Second, figure your expected return. Then divide the investment by the expected return. The result is the exclusion percentage. This is the percentage of each payment that will be excluded from gross income.

The exclusion percentage is multiplied by the first regular periodic payment. The result is the dollar amount of each annuity payment that is tax free. The excluded amount does not change in most cases even if the amount of the payment changes.

When doing your tax return, multiply the tax-free amount by the number of payments received during the year. This is your tax-free amount for the year. Subtract the tax-free amount from the total payments received during the year, and the result is the taxable portion of the annuity payments. After the end of the year, the insurer making the payments should send you a Form 1099 that shows the total amount you were paid during the year.

Over your life and that of any beneficiary, the total amount excluded from gross income cannot exceed your investment in the contract. After your full investment is recovered, all of each subsequent payment is taxable. If you and any beneficiary die before the full investment is recovered, any unrecovered investment qualifies as a miscellaneous itemized deduction on the final tax return of the last payee. This generally means if you live to life expectancy or less, part of each payment to you will be tax-free. If you live beyond life expectancy, the payments will begin to be fully taxable.

The annuity payor 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 during the year.

Those are the basic rules. There are additional rules for non-standard situations and other types of annuities. You can find more details-along with examples, worksheets, and the actuarial tables-in IRS Publication 939, General Rule for Pensions and Annuities. For payments from qualified retirement plans, the rules are in Publication 575, Pension and Annuity Income. Each is free from the IRS web site at www.irs.gov.