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How Annuities Are Taxed

how are variable annuities taxed

Submitted by Galen Weston on Wed, 12/22/2010 - 17:37

Annuities seem to get more popular with every passing year. Part of the reason for this lies in their tax deferred growth benefit. This is to say that money put into an annuity does not have its earnings taxed. Eventually though, the owner of the annuity will reach the point where he or she starts to take money out. This is when the tax deferred annuity will begin to be taxed.

Accumulation Phase of Deferred Annuities

These tax deferred annuities operate in two distinct phases. These are the accumulation stage and the distribution stage. In the accumulation stage, these annuities are growing without any taxes being taken out over the years, allowing the investment to compound its returns. This is the advantageous tax stage of the annuity's life.

When the distribution stage begins, the annuity pays out its money. This could occur as a one time sum or be scheduled as a number of payments either over the owner's lifetime or a set period of time. The scheduled payments are known as the annuitization, and the beneficiary receiving the money is the annuitant. With every annuity payment made, income taxes will become due. Should the payout be taken as a single lump sum, then the income taxes will be assessed on the difference between the value when it is paid out and the amount that was put into the annuity.

It is important to understand something about annuities and taxation when an individual takes out lump sum distributions. If a person invested fifty thousand dollars and then had an annuity valued at a hundred and fifty thousand dollars at retirement, then he or she will have to make an important decision about withdrawing it all at once. This is because annuity gains are

treated as ordinary income. So the extra hundred thousand dollars all distributed at once would be taxed at the high tax bracket for hundred thousand dollar wage earners, severely eating into the value of the payout gains.

When people instead choose to receive payments on their annuity accounts, then a portion of every payment is treated as the reimbursement of principal that has already been taxed. The other part of the payment is considered to be taxable earnings. On the part deemed to be earnings, investors will have to pay income taxes. The portion of every payment that is not taxed is determined by a set up exclusion ratio. This ratio is figured by taking the investment in the annuity and dividing it by the amount that is anticipated to be obtained in the period of the payout. To learn more about how the taxes are figured out on these annuity payments, interested readers can investigate the IRS Publication 939, entitled the General Rule for Pensions and Annuities. This will provide all of the specific information on how the taxes can be computed.

There are also annuities that pay out variable amounts. The owner can not know exactly how much will be received in every annuity payment. This results from the value of the annuity investments changing every month along with the market. The excluded amount of every annuity payment is figured in a slightly different manner. The investment is divided by the amount of time that the person will likely get the annuity payments. So if an annuity is going to make payments for two hundred and fifty months, then the amount excluded will be the total initial investment divided by this number of months. All of the amount that remained would be treated and then taxed as as ordinary income for the year.

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