Fixed annuities, like most retirement products, offer some tax relief. If you're getting close to retirement, maxed out contributions to your employer plan, or if you just plain would like to pay fewer taxes, fixed annuities may be a good option.
Have some questions about annuities? Independent insurance agents are experts when it comes to annuities, and their job is to simplify the process.
They’ll help guide you through all your options, weigh the good and the bad, and even see you through it all from start to signature.
Fixed Annuities and Taxes
According to the IRS, there are 411 publications and forms related to annuities. Sound complicated? Well, like anything else tax related, it can be. But there are some basics that will cover most situations.
While annuities have many different options, there are only two for tax purposes. Annuities are either non-tax qualified or tax-qualified. Both are taxed at ordinary income rates. Annuities are not eligible for capital gains tax treatment.
Non-tax qualified annuities are personally owned. They are paid for with after-tax dollars. Non-tax qualified annuities generally don't have loan provisions.
Tax-qualified annuities are owned by a retirement plan for the benefit of the participant. Tax-qualified annuities can be part of an IRA, 403B, and other types of plans. Tax-qualified annuities are paid for with before-tax dollars. Loans may be available if the retirement plan allows them.
Non-Qualified Fixed Annuities and Taxes
When fixed annuities are accumulating money, they are called deferred. The insurance company credits interest each year to the account value. Unlike a CD, interest is not taxable until it is withdrawn. Withdrawals from a non-qualified annuity are made on a LIFO or last-in-first-out basis. That means withdrawals are fully taxable until all of the interest credited is withdrawn. The chart below illustrates LIFO withdrawals.
75% of $25,000 Withdrawal Taxed as Gain at Ordinary Rates
When fixed annuities are paying periodic income they are called immediate, or income annuities. The income options are defined in the annuity policy, and the payments are guaranteed. A portion of the income is excluded from taxes because it is considered return of principal. Periodic income is not considered a withdrawal. Deferred annuities may be converted to income annuities at any time.
Tax-Qualified Fixed Annuities and Taxes
Tax-qualified annuities follow the rules for IRAs and other retirement plans. The contributions are made with before-tax dollars. All income from a tax-qualified annuity is 100% taxable.
Required minimum distributions (RMDs) have to be taken from a tax-qualified annuity just like any other retirement plan. The SECURE act which goes into effect January 1, 2020, raises the starting age for RMDs from 70 1/2 to 72.
Tax-qualified annuities in Roth plans follow the Roth plan rules. Contributions are made with after-tax dollars. The income is tax free.
Tax-qualified fixed annuities can provide guarantees and lifetime income, however, there is no additional tax benefit to them.
Inherited Fixed Annuities and Taxes
Non-qualified annuities are typically inherited as a death benefit paid to a named beneficiary. The death benefits are includable in the estate of the owner. The big picture is that any proceeds in excess of the contributions made by the owner are taxable to the beneficiary. The insurance company offers several options for beneficiaries depending on whether the annuity was accumulating money or paying out income. Whatever option is selected dictates when the income tax is paid. Qualified annuities follow the rules of inherited retirement plans. Generally, all proceeds from an inherited retirement plan are 100% taxable.
Tax-Free Death Benefits
Non-qualified annuities: Tax free death benefits are limited by the total contributions made to the annuity by the owner. Beneficiaries don't pay tax, however, until they have received an amount that is equal to the total contributions. Any withdrawals made by the owner treated as principal will be subtracted from the calculation.
Qualified annuities: Taxes on qualified annuities follow the rules of inherited IRAs and retirement plans. Death benefits are fully taxable. It's just a question of when the tax gets paid.
Taxable Death Benefits — Non-Qualified Annuities
Non-qualified annuities: Uncle Sam doesn’t want to let the proceeds sit in a tax-deferred account forever. The rules are that annuity death benefits must be distributed at the death of the owner. If you are a surviving spouse, you can take ownership of the annuity including any riders and death benefits within one year of your spouse's death. There is no income tax due until distributions begin.
Other options for beneficiaries are:
Five-year deferral: Take up to five years from the owner's death to withdraw the inheritance. Taxes are not due until withdrawals are taken. The money will continue to accumulate tax deferred.
Lump-sum distribution: Taxes are due in the year taken.
Stretch distribution: The distribution is taken as a percentage over time. Taxes are due as you receive the payments. The distributions may be partially or fully taxable.
Annuitization: The assets are converted into income. The payments will be partially taxable according to exclusion ratio.
Your beneficiary can decide what option to take based on their immediate needs and tax situation.
Taxable Death Benefits — Qualified Annuities
The SECURE act passed by Congress and signed by the president in 2019 takes effect January 1, 2020. The SECURE act, among other things changed the age that minimum required distributions begin from age 70 1/2 to age 72. The SECURE act also eliminated stretch IRAs for non-spouse beneficiaries. Non-spouse beneficiaries must distribute the entire inherited IRA within 10 years.
A surviving spouse has a lot of flexibility when they inherit a retirement plan. The options are different for when the owner dies before age 72 (the age required minimum distributions begin), or after age 72.
Distribution options for ROTH plans are the same as the options for traditional plans when the owner dies before age 72.
Annuity Loans and Taxes
Annuities are retirement products. By design, they are long-term investments. Using your non-qualified annuity as collateral for a loan is potentially very expensive. In addition to the interest charged, the loan can result in unexpected taxes and penalties.
Borrowing from your qualified annuity can also be very expensive, because you will be paying tax twice on the same money. The loan is repaid to your retirement account with after-tax dollars. When you eventually withdraw those dollars, you will pay tax on them again. Before you borrow from an annuity be sure to speak to your professional tax advisor.
How to Report Income from a Fixed Annuity
Distributions from non-qualified and qualified annuities are reported on form 1099R. The 1099R will be provided to you by the insurance company. 1099R income is entered on lines 4A-D on form 1040. You should consult your professional advisor for any tax or legal advice.
Why Choose an Independent Insurance Agent?
Annuities are complicated, and searching through options can be confusing, time-consuming, and frustrating. An independent insurance agent's role is to simplify the process.
They will make sure you get the right coverage that meets your unique needs and that you understand exactly what you're getting.
TrustedChoice.com Article | Reviewed by Jeffrey Green
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Required Minimum Distributions for IRA Beneficiaries IRS.Gov
Key SECURE Act Provisions and Effective Dates
BY NAPA NET STAFF DECEMBER 17, 2019
IRS publication 575