written by: Shobha Sriram•edited by: Doreen Martel•updated: 6/16/2011
Because an annuity reduces current tax cost, it is a popular investment vehicle. However, this is not always the case for beneficiaries of annuities. Annuity beneficiaries need to have a complete understanding of the taxes associated with annuities.
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Investment avenues like real estate and stocks have been accumulated for years, gained huge capital appreciation, and passed on to beneficiaries with zero tax liability. But in the case of annuities, there are no such tax benefits. Furthermore, the beneficiary of a tax-deferred annuity is also subject to income tax on the entire annuity gain.
An annuity provides high interest and deferred tax facility on the savings of annuitants. It does not levy current tax on accumulations. As it allows the compounding of yearly interest earnings tax-free, the annuitant can accumulate a large account value making the annuity a popular investment vehicle. Annuities help accumulate money safely for future utility. Only when the annuitant begins to withdraw money from the annuity, he has to pay tax on his gains. Annuitiy holders must be advised of the risks of deferred income taxes when they agree to accept an annuity contract. In the event of the death of the annuitant, the beneficiary is subject to tax. In this article, let us understand the basics of annuity contract and go over situations that describe the tax consequences for the beneficiary.
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What is an annuity?
Investors with a moderate risk tolerance need to assure themselves of a minimum income stream after retirement. An annuity contract is a retirement investment product issued and managed by insurance companies. The company receives payment from the annuitant periodically until he reaches retirement. After retirement and upon request, it provides him with a periodic payment.
The annuitant's periodic payment calculation includes factors such as his current age, current account value, expected returns adjusted for inflation and his life expectancy. Industry standard life-expectancy tables provide the life expectancy figures. The calculation also takes into account spousal provisions included in the contract. These factors ensure that longer accumulation periods in an annuity guarantees higher payments during annuity distribution period.
Since annuities are retirement instruments, they include provisions penalizing investors who withdraw funds before the passage of stipulated minimum timeline. Tax rules encourage investors to delay withdrawing funds until the annuity attains a minimum age. However, provisions in most annuities allow roughly 10-15% of the accumulations without penalty for emergency purposes.
The annuitant can hold his annuities in retirement accounts, such as IRAs or 401k plans (qualified annuities) or buy them independently (non-qualified annuities). The annuitant pays for qualified annuities with pre-tax earned dollars that are tax-deductible upon withdrawal. Non-qualified annuities are paid with after-tax dollars and do not avail any tax deductions.
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Benefits of deferred taxes
The portion of taxable income the annuitant contributes to his annuity is the amount he sets aside for deferred taxes. That results in tax savings for the year on his contributions. It is worth noting that any capital gains he accumulates in the account over his accumulation period are not taxable.
After retirement, he is likely to be in a lower tax bracket as his earnings also will probably be lesser. It also means his taxes will be lesser than the taxes he would have paid on his income had he not contributed to the annuity account.
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Tax consequences for beneficiaries
Every annuitant has to name a beneficiary to pass on his annuities in the event of his death. Tax implications on the beneficiary differ depending on whether the annuitant dies during the accumulation or the annuitization stage.
If the annuitant dies during the accumulation stage:
If the annuitant dies before the annuity contract gets converted into periodic payments, the accumulated annuity value passes on to the designated beneficiary. If the annuity is qualified, the annuity account is included in the beneficiary’s taxable income. In case it is a non-qualified annuity, the portion above the original annuitant’s contribution is included in the beneficiary’s taxable income.
If the annuitant dies after annuitization:
The beneficiary receives the remaining payments until the guaranteed period expires. He will be subjected to a similar income tax liability that the annuitant owed; that is, a portion of each payment will be subjected to tax. It is called the exclusion ratio.
If the beneficiary is a spouse:
The annuitant’s spouse can take advantage of special exceptions in death benefit distribution rules and can choose to receive a lump sum death benefit or continue the contract as a new annuitant. The special exceptions allow the spouse to delay tax payments on the accumulated annuity amount until he or she dies.