What is a Variable Annuity?

A variable annuity is a contract between you and an insurance company where the insurer agrees to make periodic payments to you, beginning immediately or in the future. You can purchase a variable annuity contract by making a single purchase payment or a series of purchase payments.

A variable annuity offers a range of investment options. The value of your investment as a variable annuity owner will vary depending on the performance of the investment options you choose. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or a combination of the three.

Although a variable annuity is typically invested in mutual funds, they differ from mutual funds in several important ways. A variable annuity can provide you with periodic payments for the rest of your life and protect against the possibility that, after you retire, you will outlive your assets. A variable annuity also comes with a death benefit, meaning that if you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount. A variable annuity is tax-deferred.

That means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer.

How Are Annuities Taxed?

When it comes to taxes, the most vital piece of information about your annuity is whether it is in a qualified or non-qualified account.

Qualified Annuity Taxation

If an annuity is funded with money on which no taxes have been previously paid, it is considered a qualified annuity. Typically, these annuities are funded with money from 401(k)s or other tax-deferred retirement accounts, such as IRAs.

When you receive payments from a qualified annuity, those payments are fully taxable as income because of the absence of taxes paid on the money.

But annuities purchased with a Roth IRA or Roth 401(k) are completely tax-free if certain requirements are met.

Non-Qualified Annuity Taxation

If the contract was purchased with after-tax funds then the annuity is considered non-qualified. These types of annuities only require tax payments on the earnings.

The amount of taxes on non-qualified annuities is determined by the exclusion ratio. The exclusion ratio calculates the percentage of annuity income payments that are taxable and how much is not. The idea is to determine the amount of a withdrawal or payment from an annuity is from the already-taxed principal and how much is considered taxable earnings.

The exclusion ratio involves the principle that was used to purchase the annuity, the amount of time the annuity has existed, and the interest earnings.

If an annuitant lives longer than their actuarial life expectancy, any annuity payments received after that age are fully taxable.

That’s because the exclusion ratio is calculated to spread principal withdrawals over the annuitant’s life expectancy. Once all the principal has been considered, any remaining income payments or withdrawals are from earnings.

Exclusion Ratio Example

• Your life expectancy is 10 years at retirement.

• You have an annuity purchased for $40,000 with after-tax money.

• Annual payments of $4,000 – 10 percent of your original investment – is nontaxable.

• You live longer than 10 years.

• The money you receive beyond that 10-year-life expectation will be taxed as

income.

Annuity Withdrawal Taxation

How and when you withdraw funds from your annuity also affects your tax bill.

In general, if you withdraw money from your annuity before you turn 59 ½, you may owe a 10 percent penalty on the taxable portion of the withdrawal.

After that age, taking your withdrawal as a lump sum rather than an income stream will trigger the tax on your earnings. You’ll have to pay income taxes that year on the entire taxable portion of the funds.

If money is left in your annuity account, the IRS considers the first and subsequent withdrawals to be interest and subject to taxes.

Regardless of how you withdraw the money, the tax status of the contract, whether qualified or non-qualified, determines how much of the withdrawal will be taxed. If it’s a qualified annuity, you will pay taxes on the full withdrawal amount. If it is non-qualified, you will pay income taxes on the earnings only.

Annuity Payout Taxation

According to General Rule for Pensions and Annuities by the Internal Revenue Service, as a general rule, each monthly annuity income payment from a non-qualified plan is made up of two parts. The tax-free part is considered the return of your net cost for purchasing the annuity. The rest is the taxable balance or the earnings. When you receive income payments from your annuity, as opposed to withdrawals, the idea is to evenly divide the principal amount — and its tax exclusions — out over the expected number of payments. The rest of the amount in each payment is considered earnings subject to income taxes.

Inherited Annuity Taxation

If you are the beneficiary and inherit an annuity, the same tax rules apply. The main rule about taxation with an inherited annuity or one that is purchased is that any principal that is funded with money that was already subject to taxes will still not be taxed. The principal not taxed on and earnings will be subject to taxation as income. The amount of previously taxed principal included in each annuity income payment is excluded from federal income tax requirements. This is known as the exclusion amount.

What is the Annuitization Period?

The annuitization period of an annuity is the specific time during which annuity income payments are made to annuitants. This may be either a fixed period or an annuity lifetime. If the annuitant outlives this period, annuity payments stop, and annuitization is considered concluding.

Annuities can be taxed differently depending on whether annuitization occurs over the annuitant's lifetime or a specific annuitization annuity period. Some annuities may provide additional tax deferral for annuitants as well as income credits and return of premiums.

Annuities are usually marketed as either fixed or variable annuities, according to their method of payment. SGLI is the annuity offered to members of the uniformed services.

Key Takeaways

There are many types of annuities, and some may be more appropriate for your financial situation than others. The type you choose will depend on the amount of risk you're willing to take with your money, how much time you have before retirement, and other factors that affect the way annuities are taxed. If there's something about annuity taxes or any other aspect of this topic that still leaves you scratching your head after reading through our post, don't hesitate to reach out! Our team is ready to help schedule a meeting so we can further discuss all things related to long-term income planning in detail.

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Disclosure: With a variable annuity, you will pay a Mortality and Expense (M&E) fee, which helps cover the guarantees they provide. Variable annuity investors also pay underlying fund expenses, and in some cases, an annual contract charge. A surrender charge may apply to withdrawals during the surrender charge period. Each annuity has different features and benefits that may be appropriate for you based on your financial situation and needs, your risk tolerance, your age and how you intend to use the annuity. The different features and benefits may include the investment options, fund managers, interest rates, guarantees, bonus crediting, surrender charge schedules, optional riders and liquidity (access to your money without fees or charges). The fees and charges may also be different among the annuity contracts. You should consider the investment objectives, risks, charges and expenses of the variable annuity and its underlying investment options carefully before investing. Read the prospectus carefully before you invest. Diversification helps you spread risk throughout your portfolio, so investments that do poorly may be balanced by others that do relatively better. Diversification does not assure a profit or protect against loss.

Investment advisory services are offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.

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