7.4 Income Tax Treatment of Benefits
"UNCLE SAM WANTS YOU..."
Of course he does - and annuities are not excluded - with the exception of some distinct income tax advantages.
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Taxes are only paid when interest is withdrawn. - Just like the IRA, the 10% excise tax penalty exists.
- The exclusion ratio allows clients to receive income partially income tax free.
- Section 1035(a) exchanges are a way to move annuity funds income tax free.
How is the capital gains tax determined for an individual during the accumulation period of a variable annuity, and the payout period?
There is no capital gains tax to the individual during the accumulation period of a variable annuity.
The amount of each annuity payment, including capital gains appreciation in excess of the tax-free return, is taxed as ordinary income during the period of payout.
Effective with all annuity starting dates after 12/31/1986, payments become fully taxable after the owner recovers the total of all premiums paid into the contract (determined by adding all dollars excluded from taxes). After the contract owner has lived beyond his life expectancy (as calculated when payments began), payments then become fully taxable.
The main advantage of annuities is their tax-deferred feature, which allows an annuity owner to accumulate more money as compared to fully taxed investments. This is one of the main reasons many people are choosing tax deferred annuities as the foundation of their overall financial plan, and retirement planning in particular.
The 10% excise penalty tax imposed before the annuitant reaches age 59 1/2 is due to the mere fact that the tax deferred annuity is specifically designed as a retirement supplement. However, no ceiling is imposed and the purchaser does not need earned income to qualify. Typically, the annuity owner can withdraw up to 10% of the initial premium investment each year (after the first anniversary) without surrender charges. There are circumstances, however, under which the 10% excise penalty is avoided, such as:
- taxpayer disability;
- distribution from a pre-8/14/1982 annuity;
- death of the owner (but death of annuitant for annuities issued before 4/23/1987);
- payment from an immediate annuity where benefits commence within one year of purchase;
- payment from a structured settlement;* and
- substantially equal payments over the taxpayer's life expectancy.
*A structured settlement occurs when an annuity is used to distribute funds from the settlement of lawsuits or the winnings of lotteries and other contests.
A personal tax advisor should always be consulted as insurance agents are not trained or qualified to provide tax advice. The understanding of basic annuity taxation only allows an agent to help people accumulate more money, not provide tax advice.
