Non-Qualified Annuity Tax Rules
Annuities have become increasingly popular. Tax deferred growth is arguably the most appealing feature of a non-qualified annuity. This permits earnings on premiums to avoid income taxation until distribution. Long-term savings advantages and the ability to insure an income stream for life add to annuities' increasing appeal. As a consequence of their rising popularity, the past few years have brought a significant increase in the number of available annuity products.
In this article we review some of the most common tax concerns that arise around non-qualified annuities. Armed with this information, current and future annuity owners can proactively navigate around them. Before we start, though, its important to advise that the information on this page should not be taken as tax advice. You should consult with a competent tax professional before buying an annuity or before making changes to any existing annuity which may potentially trigger a taxable event.
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Types of Annuities
Annuities are classified in a number of different ways. For federal tax purposes, annuities are classified as either qualified or non-qualified. A qualified annuity is purchased as part of, or in conjunction with, an employer provided retirement plan or an individual retirement arrangement (such as an Individual Retirement Annuity or a Simplified Employee Pension Plan). If certain requirements are satisfied, contributions made to qualified annuities may be wholly or partially deductible from the taxable income of the individual or employer making the contributions.
A non-qualified annuity is not part of an employer provided retirement program and may be purchased by any individual or entity. Contributions to non-qualified annuities are made with after-tax dollars and are not deductible from gross income for income tax purposes. For the purposes of this article, we will limit further discussion to non-qualified annuities.
Annuities are also classified by type of investment and type of payout. Under a fixed annuity, the owner has both the security of a set rate of return and no investment decisions related to the annuity funds. The title "fixed annuity" does not mean that the earnings rate credited will never change; rather, it means that the earnings rate is set periodically by the issuer and then "fixed" until the rate is changed again.
Parties To an Annuity Contract
The three parties to an annuity contract are the owner, the annuitant, and the beneficiary. In many instances, the owner and the annuitant will be the same.
The owner is usually the purchaser of the annuity and has all the rights under the contract, subject to the rights of any irrevocable beneficiary. The owner is subject to income tax on all payments made from the annuity, regardless of who is named as payee or annuitant if different than the owner). When applicable, the penalty on any premature distributions is based on the owner's age. If the owner dies while the contract is in the accumulation phase (discussed later), there usually is a mandatory distribution of the death benefit (except when a spousal continuation rider takes effect).
The owner names the annuitant and the beneficiary of the annuity contract. The annuitant must be a natural person and serves as the measuring life for purposes of determining the amount and duration of any annuity payments made under the contract. The beneficiary receives the death benefit or any remaining annuity payments upon the death of the owner.
Natural Owner of an Annuity
The owner of an annuity may be a natural or non-natural person. A natural person is a human being, for example. Some examples of non-natural persons are corporations, partnerships, and trusts.
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An annuity contract will be treated as owned by a natural person even if the owner is a trust or other entity as long as that entity holds the annuity as an agent for a natural person. However, this special exception will not apply in the case of an employer who is the nominal owner of an annuity contract under a non-qualified deferred compensation arrangement for its employees. Immediate annuities are also excepted from the non-natural owner rule.
Why is it important to know if the owner is a natural person? Generally, only annuity contracts owned by natural persons are treated as annuity contracts for federal income tax purposes and the earnings on such contracts are taxed deferred until withdrawn. On the other hand, annuity contracts owned by non-natural persons are not treated as annuity contracts for federal income tax purposes and the earnings on such contracts are taxed annually as ordinary income received or accrued by the owner during the taxable year. As with many other income taxation rules, there are several exceptions to the non-natural owner rule.
Non-Natural Owner of an Annuity
As stated earlier, contracts owned by "non-natural" persons are subject to annual tax on the inside buildup in the contract. Notable exceptions are contracts held in a trust or other entity as an agent for a natural person, immediate annuities, annuities acquired by an estate upon the death of the owner. Annuities are also not taxable if owned by a charitable organization or a pension plan.
Aggregation Rules
Purchasing several individual annuity contracts from a single insurance company within the same calendar year is often referred to as aggregation. In this scenario, the IRS treats these purchases as a single transaction in order to prevent the owner of the policies from manipulating the basis in each contract. Aggregation can result in an unexpected tax liability for the annuity owner. This rule does not apply when contracts are purchased from different insurance companies or if one annuity is deferred and another is immediate.
All contracts issued by the same company to the same policyholder during any calendar year will be treated as one contract for purposes of computing taxable distributions.
The following are exceptions to the aggregation rules: deferred annuity contracts which are exchanged into immediate annuities; immediate annuities; distributions required on account of the death of the owner; contracts issued prior to 10/21/88. Note, if a pre-10/21/88 contract is subsequently exchanged or transferred, the new contract becomes subject to the aggregation rules.
Premature Distribution Penalty
Penalty:
10% of taxable amount.
Exceptions:
1. The owner is over age 59½ 2. The owner is disabled after contract purchase 3. The owner, not the non-owner annuitant, dies 4. Pre-TEFRA (prior to 8/14/82 contributions) non-qualified money 5. Immediate non-qualified annuity
Substantially equal payments
1. Must continue for 5 years or until owner reaches 59½, whichever is later 2. Must be computed based on life expectancy 3. Annuitization (for the owner's life or life expectancy
Note: An exchange from a deferred to an immediate annuity does not qualify as an immediate annuity for the purposes of avoiding tax penalty.
Tax Consequences of Ownership Changes
Types:
- Addition/deletion of joint owner
- Transfer to another individual or entity
- Assignment
Taxation:
- Earnings are subject to income tax at time of transfer
- 10% penalty may apply
- Gift taxes may apply
Exceptions:
- Transfers between spouses
- Transfers incident to divorce
- Transfers between an individual and his/her grantor trust
Mandatory Distribution upon Death of Owner
If Owner dies Prior to Annuitization:
Surviving owner (or beneficiary) must elect one of the following:
- immediate lump sum
- complete withdrawal(s) within 5 years of death
- annuitization (over the life of the new owner) to start within one year of death. If spouse is sole surviving owner (or beneficiary), spouse can also elect to continue contract. If owner is a grantor trust, death of grantor triggers mandatory distribution
Mandatory distribution applies to all contracts issued after 1/18/85
If Owner Dies After Annuitization:
Payments continue to beneficiary, based on annuitant's life and type of payment plan chosen
What are the phases of the annuity contract?
There are two distinct phases of the annuity contract: the accumulation phase and the annuitization phase. During the accumulation phase, the owner generally is not taxed on the earnings credited to the cash value of the annuity contract unless a distribution is received. The accumulation phase continues until the annuity contract is terminated or the annuitization phase begins. The annuitization phase starts when the contract value is applied to an annuity payout option. This phase continues until the last payment is made according to the annuity payout period chosen by the owner (or in some cases, the beneficiary).
How are the distributions taxed during the accumulation phase?
When an annuity contract is fully surrendered during the accumulation phase, the owner must pay income tax on the earnings in the contract. The owner is not taxed on amounts that represent a return of contributions (such as premiums or investment in the contract). Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis. In order words, withdrawals from an annuity are made earnings first, and the owner is taxed on the payments until all of the earnings have been distributed. There is an exception to the earnings first rule for contributions made to annuity contracts prior to 8/14/82. These contributions are distributed on a first in, first out (FIFO) basis and the owner is not taxed until such contributions are fully recovered.
There is an aggregation rule which requires that all annuity contracts issued by the same company, to the same owner, in the same calendar year must be treated as one annuity contract for purposes of determining the taxable portion of any distributions.
How are distributions taxed during the annuitization phase?
Early Annuitization:
Annuities are designed to function as retirement investment vehicles, placing withdrawals after the attained age of 59 1/2. Should the annuity owner begin withdrawals following this age and assuming that they have satisfied any relevant surrender schedule, they will not be assessed fees outside of their tax liabilities. However, should the annuity owner opt to receive withdrawals prior to reaching the age of 59 ½, they may be subject to a 10% IRS penalty on any gains posted to-date. One exception to this rule is if the annuity owner has established an agreement with the IRS, referred to as substantially equal periodic payments (SEPP). Under this agreement, equal withdrawal payments can begin prior to the annuity owner’s age of 59 ½ without penalty as long as they continue to the agreed upon future date, which at a minimum is the later of age 59 ½ or a 5 year period.
During annuitization, a portion of each annuity payment represents a return of non-taxable investment in the contract and the balance of each payment is considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio. The exclusion ratio for a fixed annuity is the ratio the investment in the contract bears to the expected return under the contract. The exclusion ratio for a variable annuity is determined by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered using the exclusion ratio, the annuity payments are fully taxable. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner in his last taxable year.
When does the 10% penalty tax apply?
The 10% penalty tax generally applies to the taxable amount of distributions from annuities made before the owner attains age 59½. However, there are exceptions for distributions: (1) made as a result of the owner's death or disability; (2) made in substantially equal periodic payments over the life or life expectancy of the owner, or joint lives or joint life expectancy of the owner and designated beneficiary; (3) made under an immediate annuity; or (4) attributable to investment in the annuity made prior to 8/14/82.
What happens at the owners' death?
Distributions
If the owner dies after the annuitization phase has begun, the remaining payments, if any, must be paid out at least as rapidly as under the annuity payout option in effect at the time of the owner's death. If a beneficiary receives the remaining payments under the annuity payout option in effect at the owner's death, the taxable and nontaxable portions of such payments will continue to be determined by the original exclusion ratio.
Withdrawals
Pre-TEFRA Contracts (Prior to 8/14/82):
- Principal out first - Not taxable
- Earnings outlast - fully taxable, but no penalty tax
Post TEFRA Contracts (After 8/13/82)
- Earnings out first - Fully taxable and may be subject to penalty tax
- Principal out last - Not taxable
Notes:
If a pre-TEFRA contract is subsequently exchanged, it keeps pre-TEFRA tax treatment. Sub-accounts are combined to compute income in the contract.
If the owner dies during the accumulation phase, the entire death benefit must be distributed within five years of the date of the owner's death. However, there is an exception to the five-year rule, if the death benefit is paid as an annuity over the life, or a period not longer than the life expectancy, of the beneficiary and the payments start within one year of the owner's date of death. If an annuity contract has joint owners, the distribution at death rules are applied upon the first death.
Under a special exception to the distribution at death rules, if the beneficiary is the surviving spouse of the owner, the annuity contract may be continued with the surviving spouse as the owner. If the owner of the annuity is a non-natural owner, then the annuitant's death triggers the distribution at death rules. In addition, the distribution at death rules are also triggered by a change in the annuitant on an annuity contract owned by a non-natural person. Income Tax. Unlike death benefits paid from life insurance policies, the beneficiary may be taxed on distributions made from an annuity after the owner's death. Amounts paid under the five-year rule are taxed in the same manner as partial withdrawals or full surrenders, and amounts paid under an annuity option are taxed in the same manner as annuity payments. For variable annuity contracts issued on or after 10/29/79, and for all fixed annuity contracts, there is no "step-up" in basis for income tax purposes and the beneficiary pays income tax on the earnings. However, the beneficiary is entitled to deduct a portion of estate tax paid on the annuity for income tax purposes. For variable annuity contracts issued prior to 10/21/79, there is a "step-up" in basis for income tax purposes and no income tax is payable on the earnings.
Deducting Capital Losses
If the annuity owner receives a lump sum distribution at a value below their cost basis, they may be able to claim the loss on their federal tax return if they itemize. Surrender charges assessed to the annuity owner following a withdrawal or surrender will not qualify as a loss under this ruling.
Classification of the Annuity’s Owner as a Trust
When the owner of a nonqualified annuity is a non-natural person, such as a trust, it is taxed on an annual basis and is ineligible for tax deferral benefits. One exception does exist; should the trust act in an agent capacity.
Trusts Listed as an Annuity’s Beneficiary
Most annuities offer three primary distribution options to listed beneficiaries; lump sum payment, even payments over a five year period or income payments over the life of the named beneficiary(ies). Should the beneficiary of the annuity be the spouse of the original owner, an additional option may be presented; for the surviving spouse to step in as the new owner of the annuity. If a trust is listed as the annuity’s beneficiary, no-look through provisions are offered. Essentially what this means is that the trust is ineligible to receive lifetime income payments. One exception to this general rule does apply; should the trust act as an agent of the spouse’s named beneficiary.
Gifting an Annuity
When an annuity is gifted to another party, the transaction triggers a taxable event for the donor. Any relevant capital gains will be taxed at the current owner’s tax bracket. And, should the gift occur prior to the annuity owner’s age of 59 ½, the transaction will be subject to a 10% IRS early withdrawal penalty. Two exceptions may apply; should the transfer occur between spouses or former spouse (as in the event of a divorce settlement), or if the annuity was issued prior to April 23, 1987. Annuities issued prior to this date will be taxed following donation when the contract is surrendered rather than at the time of transfer.
Grandfathered Annuities
Some previously purchased contracts may be eligible to receive favorable tax treatment. Withdrawals from annuities purchased prior to August 14, 1982 are subject to the first in, first out treatment. A step up in basis will be provided to beneficiaries of annuities purchased before October 21, 1979 upon the original contract owner’s death. If these original contracts are exchanged, these grandfathered benefits will be forfeited.
Required Minimum Distributions
IRAs with annuity holdings are subject to the IRS rule known as required minimum distributions (RMDs), which triggers when an individual reaches the age of 70 ½. RMD withdrawals, however, are NOT required to be taken from a non-qualified annuity. Simply stated, the concept of RMDs does not apply with non-qualified annuities.
Estate Tax
For federal estate tax purposes, the total value of the contract is subject to estate tax. Except as noted above, annuities are income in respect of a decedent and there is no "step-up" in basis for the contract and the annuity is subject to income tax when distributed.
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Comments (65)
Ken
2015-02-09 12:52:36
I bought a $100,000 non-qualified fixed annuity. I withdraw the interest I earn each month keeping the principal at $100,000. Every year I pay taxes on this interest. When the surrender fee period ended last year I withdrew $30,000 from the principal, leaving $70,000 in the annuity. Today I received a 1099-R from the insurance company showing a taxable amount for last year's withdrawals that included the interest plus $30,000 of principal. What should I do?
Hersh Stern (ImmediateAnnuities.com)
2015-02-09 12:55:39
Hi Ken-
From the facts you described, the return of principal after all interest was withdrawn should have been coded as a non-taxable event. You may know that withdrawals from non-qualified annuities are taxed under the "LIFO" or Last-In-First-Out rule. So each year's interest was correctly accounted for as taxable. But once there's no interest left in your contract and you make another withdrawal, that last amount should have been described as non-taxable.
What to do next?
I'd start by calling the company and letting them know that their computer mistakenly lumped together the taxable interest amount with the principal amount. They should agree to send you a corrected 1099, which may take a few weeks for you to receive.
If you don't get the response you want, attach a brief letter to the incorrect 1099 when you file your taxes. Explain to the IRS why the 1099 is wrong. That should put it to rest. I wouldn't stress too much about this since these kinds of mistakes do happen and 99% of the time the IRS will accept a policyholder's explanation.
-Hersh
Sunghee
2015-02-11 15:09:22
I surrendered my non-qualified variable annuity after 7 years. I received a Form 1099-R distribution notice from the insurance company which shows I received an amount that was a lot less than my initial investment. Where can I deduct this loss? Thank you.
Sunghee
Hersh Stern (ImmediateAnnuities.com)
2015-02-11 15:44:05
Hi Sunghee,
There are several steps to recognizing a loss from a variable annuity. Before you do anything though I strongly advise you to consult a CPA or tax attorney because the law is a bit fuzzy about what I'm telling you here:
1. You start by surrendering your annuity for its cash value. You cannot take a loss if you just exchange your annuity for another one under Section 1035.
2. You then calculate your "cost basis." This is the amount you originally paid for the annuity plus any additional premiums paid over time minus any withdrawals you took. If you were charged a surrender fee when cancelling the annuity that penalty needs to be added back in because surrender fees do not figure in your calculations of your reportable loss.
3. There are two ways you can report your loss on a tax return. First, know that this kind of loss is not an "investment" or capital loss. So you can't offset profits from mutual funds or stock sales with an annuity loss.
First approach: An annuity loss could be considered an "ordinary" loss which you include with your itemized deductions under "Miscellaneous Deductions." This would be a deduction only to the extent that your total Itemized Deductions exceeded 2% of your Adjusted Gross Income (AGI).
Second approach: Some CPAs are more aggressive and tell you to deduct the full loss not just up to 2% of your AGI. They say you can enter your loss under the "Other Gains/Losses" section of your tax return. The precedent for this interpretation is Revenue Ruling 61-201, 1961-2, CB46.
Either way, be sure to get a written opinion from a CPA or tax specialist. This is not intended to be proper tax advice. Please don't rely on my opinion.
-Hersh
Wilson
2015-03-09 15:14:19
I have had a non-qualified annuity for 15 years. I would like to close it out. My statement shows a value listed as 'tax basis' and another for 'taxable gain'. Is the taxable gain the value I will have to pay taxes on when I receive my 1099-R? I am not yet 59-1/2 years old. Will there be an IRS 10% penalty even though I have held the annuity until maturity and there are no longer surrender fees?
Hersh Stern (ImmediateAnnuities.com)
2015-03-09 15:17:52
Hi Wilson,
I'm afraid you will be subject to the 10% federal tax penalty on the taxable gains amount. The fact that you waited until your contract surrender fees no longer apply permits you to remove all the money without being charged a fee by the insurance company. But that's a separate matter from the IRS penalty which I believe you are subject to unless you qualify for one of the listed exemptions to the penalty tax.
-Hersh
John B.
2015-04-04 10:49:27
My wife and her sister were made owners of a non-qualified annuity from their father. Both are under 59 1/2. During 2014 my sister-in-law took what we later found out was an early withdrawal, sending my wife half of the amount. We later recieved a 1099-R for the distribution. These funds put us in a higher tax bracket, we lost out ability to deduct our traditional IRA and increased our tax liability greatly. In essence, more than one third of the distribution went to taxes. What could we have done with this money to minimize the tax burden?
John
Sam
2015-04-06 09:38:58
My father passed away last December and had a non-qualified annuity. My mother is the beneficiary. What are the tax implications if she took the lump sum or had it distributed over the next five years?
Hersh Stern (ImmediateAnnuities.com)
2015-04-06 09:42:02
Hi Sam-
For the benefit of other readers I'll first define a non-qualified annuity. That's an annuity purchased with after-tax savings. The IRS calls it non-qualified because the initial investment or premium was not pre-tax money. Pre-tax money would be IRA or 401k accounts, where the cash value has never been taxed. Pre-tax money has "qualified" for favorable tax treatment.
It's important to know since the non-qualified annuity was bought with savings that had already been taxed, that only the new earnings or growth would be subject to new taxes (because that money hasn't been taxed).
Now to your question. If the current cash value of your father's annuity is greater than his original investment (i.e., the premium, sometimes referred to as his "cost basis" in the contract) that difference is subject to income tax.
Here's an example: He invested $100,000. It grew by $50,000. He previously withdrew $15,000. The current value is $135,000. The taxable gain would be $35,000.
If your mother receives the full cash value in a lump sum, she'll owe taxes this year on the $35,000. If she accepts a 5-year payout then for each of the next 5 years she'll owe taxes on $7,000 per year.
-Hersh
Charlene
2015-04-07 12:22:24
Is there tax due on gains when a person moves money from one non-qualified annuity to another in the year the change is made, or only when a person begins taking the money? The transfer of funds was done by the companies involved, I did not receive any of it directly.
Hersh Stern (ImmediateAnnuities.com)
2015-04-07 12:25:43
Hi Charlene-
If there was a direct exchange of your annuity's cash value between two companies then you should not owe any tax on the gains.
You can read more about that here:
https://www.immediateannuities.com/1035-annuity-exchanges/
Hersh
Joanne
2015-04-08 09:58:05
My father is deceased. When he was in the military he paid into an Annuity. My mother receives income from the annuity and gets a 1099-R each year showing the taxable income amount and taxes withheld. When I went to enter this information in a tax program, it asked me if her "distribution" was qualified or non-qualified, and I am unsure which one I should select. Those were the only 2 choices. I thought a "distribution" was from an IRA or something like that, but this is a monthly check she receives from the Defense Finance and Accounting Service, US Military Annuitant Pay. Can you help me? Is this monthly annuity qualified or non-qualified?
Hersh Stern (ImmediateAnnuities.com)
2015-04-08 10:01:27
Hi Joanne-
I'll tell you how to find the answer to your question. But, first, a brief explanation of the term "qualified."
If the money your father invested in his annuity was pre-tax money (for example, he set aside some of his salary each week before any income taxes were paid, and had it deposited into the annuity) then his deposits would be considered similar to deductible contributions made into an IRA. To be able do have made such pre-tax deposits his annuity plan must have "qualified" under IRS rules permitting such favorable tax treatment.
If this was the case, then, today, all the income derived from his annuity would be fully taxable, since no taxes had ever been paid on either the principal or the gains.
Looking at the 1099-R your mother received, does the taxable income amount shown equal all the income your mother received last year? If yes, then that this must be a "qualified" annuity!
If, however, not all the income your mother received last year was coded as taxable on the 1099, then your father probably contributed "after-tax" money into the annuity and it would be designated "non-qualified." The advantage here is that since the principal had already been taxed years ago, only the untaxed earnings or gains are now subject to income tax. This would be apparent from the 1099.
Hope this helped.
Hersh
Joanne
2015-04-08 11:43:56
Follow up to my question about the military annuity -- yes, the box showing "Gross Distribution" has the same amount in it as the box showing "Taxable amount," so then I believe it would be "qualified." I thank you so much for this answer!
Robert
2015-04-16 12:41:27
I have an annuity with an income rider. When I start taking money out, how is it taxed? I understand that any amount I withdraw is taxed. Is that true?
Hersh Stern (ImmediateAnnuities.com)
2015-04-17 10:54:40
HI Robert-
First, if your annuity was purchased with IRA or 401k monies then all withdrawals are taxed for the life of the annuity. This type of annuity is called "qualified."
If, however, your annuity was purchased with after-tax savings then you only owe income tax on the gains, but not on the original premium. This is called a "non-qualified" annuity.
It's important to know that the IRS designates the first monies withdrawn from a non-qualified annuity under an income rider to be the GAINS (when there are gains), not a withdrawal from your principal or original premium.
This is known as the LIFO rule, for "Last In, First Out."
In your case, the FIRST IN money is the original after-tax premium you paid for your annuity. After investing that premium, the LAST IN money is the gains or interest you earned each year.
So when you withdraw money from the annuity, the IRS considered the "Last IN" money, (i.e., the interest or gains which went into your contract AFTER the initial premium was paid in) to be coming out "FIRST" (i.e., "First Out").
If you decide to "annuitize" your contract instead of using the income rider, your withdrawals would be taxed under the pro-rata method instead of LIFO. That's how immediate annuities are taxed.
Hersh
Muriel
2015-04-21 10:19:52
Last year I withdrew all the cash from my non-qualified annuity. The 1099-R I received today shows a Distribution Code of 7D . What is that?
Hersh Stern (ImmediateAnnuities.com)
2015-04-21 10:22:17
Hi Muriel-
The letter "D" identifies your annuity as non-qualified. The number "7" indicates that you are at least 59-1/2 years old.
Box 2a shows you the taxable amount of the distribution. If this amount seems wrong call the insurance company. A discrepancy can sometimes happen if you exchanged a previous annuity for this one and the cost basis information was not correctly reported by the prior company or recorded by the new company.
-Hersh
Mike
2015-04-29 16:02:45
I had a question on immediate annuities regarding income taxes. If my employer purchases the annuity as part of a severance / early retirement negotiation can I pay income taxes as I receive the income or do I have to pay all at once?
Hersh Stern (ImmediateAnnuities.com)
2015-04-29 16:17:57
Hi Mike-
To correctly answer your question I'd need to know more about the source of the money that's going towards the purchase of this annuity and who will be the owner once it's issued.
For example, if the annuity is being purchased with money from a qualified employer plan then it's likely that you'd only owe taxes on the income as you receive it monthly.
Similarly, if your annuity is not funded with qualified plan money, but your employer will own the annuity after it's issued, then again, you should only be liable for taxes as you receive income. In this case, you're said to not have "constructive receipt" of the premium nor ownership of the annuity.
But, if this annuity is being given to you in lieu of salary and you'll own it, then you may actually owe taxes on the full cost of annuity even though you didn't receive the lump-sum to buy it.
Ask your employer if you'll be receiving a W-2 or 1099-MISC at the end of the year in the dollar amount of the annuity purchase price. That's a dead ringer you'll owe taxes on the full amount this year.
I strongly suggest you consult a CPA or tax attorney soon, before you sign on the dotted line, so you know ahead of time what your tax obligation is on this money.
Hersh
John
2015-05-06 10:02:11
Is the taxable portion of an immediate annuity taxed as ordinary income or dividends?
Hersh Stern (ImmediateAnnuities.com)
2015-05-06 10:03:53
Hi John-
The taxable portion of an immediate annuity is taxed as ordinary income.
When you purchase, you'll get a Form 1099-R from the insurance company showing the taxable amount every January.
Hersh
Adam
2015-05-06 10:23:47
To follow up on Mike's question, I own my own company and was considering having my company buy me an annuity in lieu of normal compensation. Would there be a tax benefit to leaving the company as the owner and me as the annuitant?
Hersh Stern (ImmediateAnnuities.com)
2015-05-06 10:25:38
Hi Adam-
As I mentioned to Mike, best to get an opinion from a CPA.
Off the top of my head, one concern with having your company own the annuity is that it would be liable for the annual taxes on payments you receive. That can be handled by the company issuing a "wash 1099" to you under nominee income rules. Your CPA can help with that.
Another that comes to mind is that if your corporation was liable for some large claim the annuity could be attached to cover payments owed on account of the claim. Whereas, if you personally owned the annuity it might be exempt from the reach of creditors. That would be governed by the bankruptcy laws in your state. Again, this gets into areas best discussed with someone intimately involved with the legal and tax status of your company.
Hersh
Robert
2015-05-15 14:01:19
When I buy an immediate annuity do they automatically withhold income taxes?
Hersh Stern (ImmediateAnnuities.com)
2015-05-15 14:02:58
Hi Robert-
On the annuity application there's a section where choose whether to have income taxes withheld from your monthly payments or not.
There's also a check box to enter a dollar amount to be withheld, a percentage, or let the company calculate withholding based on the number of allowances you enter on the form.
Also, you can change this election any time. Many of my newly-retired clients postpone withholding until their second policy year when they have a clearer picture of their income level in retirement. Or, you can start with a conservative percentage and raise it as needed. Again, this is at your discretion and I'll help you to figure it out when you apply.
Hersh
Donald
2015-08-25 07:50:35
I have an IRA with both pre-tax and non-deductible contributions. The custodian firm doesn't have my cost basis back to 1988 when I started making non-deductible contributions. They said if I transfer the money in my IRA to an immediate annuity they would report it as all pre-tax money which would make my monthly income fully taxable. How could I substantiate the transfer so the non-deductible portion is treated as nonqualified.
Hersh Stern (ImmediateAnnuities.com)
2015-08-25 07:52:01
Hi Donald-
Before I go further I'm advising you to speak with a CPA or tax attorney. I'm neither.
An option you might consider would be to "force" the issue by taking a full distribution. Deposit the check in your regular checking account. Then buy the annuity soon after so the IRA portion is rolled over to the new IRA annuity within the 60 days allowed for that. Next year, the custodian will report to the IRS on a 1099 that the full distribution amount was fully taxable. When you file your taxes, attach a detailed letter of explanation showing the IRS your calculation of the pre-tax and post-tax contributions. You can also include a copy of your annuity Data Page to show the IRS that you rolled over the pre-tax-IRA money into a new IRA (that's the annuity) within the 60 days.
This approach usually works, but again, speak with a CPA before you do this.
Hersh
Ginny
2018-10-29 08:30:22
My husband is retiring at age 57. He has a pension through his work and has received a packet in which to decide how he wants it. With the lifetime annuity option is there a tax penalty because he is 57 and not 59 1/2? If so is that penalty removed once he is 59 1/2?
Hersh Stern (ImmediateAnnuities.com)
2018-10-29 08:32:12
Hi Ginny,
I want to preface this with saying you should always consult with a tax adviser or CPA with any tax related questions.
That being said, it is my understanding that annuities fall into the tax penalty exception of "substantially equal periodic payments":
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-substantially-equal-periodic-payments#2
As long as your husband buys an annuity that will continue to pay for his entire lifetime, then according to the above IRS website, he should not receive any IRS penalties.
However, I do recommend you speak with a CPA.
-Hersh
Ed
2019-03-22 13:24:59
I have been funding my Roth every year. What part of the Roth my I invest in an annuity?
Hersh Stern (ImmediateAnnuities.com)
2019-03-22 13:26:25
You should be able to invest the entire amount of your Roth IRA into the annuity as long as:
-You have had the Roth IRA for at least 5 years.
-You have not converted any traditional IRA monies into the Roth for at least 5 years.
-You meet the suitability guidelines for the annuity (generally, not putting more than 50% of your liquid net worth into the annuity)
As long as those criteria are met, then any amount, up to its entirety, can be invested into an annuity.
-Hersh
Thomas
2019-05-02 10:43:58
I have a pretax IRA type annuity with a life insurance company where I have to take RMDs every year. Can I open up an account with a 401-k and then transfer to a new company from the present one since my 7 year contract has expired? Also do I pay a fee to the present company when transferring out?
Hersh Stern (ImmediateAnnuities.com)
2019-05-02 10:46:38
Hi Thomas,
Yes, you can use 401k funds and then move the money over from your IRA annuity as well into the same annuity. If you have waited until the end of your 7-year term, you should be able to move your funds to a new insurance company free of any fees or taxation. It will simply be a tax-free transfer or rollover from one IRA to another, though it is always best to check with your current company on their policies regarding fees.
-Hersh
Kevin
2019-10-21 10:22:04
I am thinking of cashing in my mutual funds that I inherited from my mother (not employer related) to buy an immediate fixed annuity.
Question one. Taxes will be paid on the capital gains so the money should be "after tax", correct?.
Question two is that I should only be worried about paying taxes on the taxable portion of the immediate annuity correct?
Question Three. Once the contract is set up-can the cash flow rate be changed yearly by the insurance company?
Hersh Stern (ImmediateAnnuities.com)
2019-10-21 10:24:55
Hi Kevin,
The first thing I'd like to say is that we're not tax experts. Any taxation questions should be reviewed by a CPA or tax adviser.
To answer your questions in order:
1. If all taxes have been paid on the funds used to purchase the annuity, then it will be considered "Non-Qualified" or "after tax".
2. You are correct, the only money you need to pay taxes on will be the taxable portion of each payment until the entire premium has been paid back. At that time, the payments will be fully taxable as they will become entirely interest.
3. The only time the cash flow rate can change is if you purchase a Cost of Living Adjustment (COLA) with the annuity. If you do not have a COLA on the contract, then the cash flow rate will stay the same throughout the life of the contract.
Alberto C.
2022-08-10 18:30:13
Does the 10% early withdrawal penalty apply to the ages of both owner's if it's a jointly owned NQ annuity? Or does it only apply to the age of the primary owner/annuitant?
Kyle
2022-08-15 13:57:32
Hi Alberto,
Thank you for reaching out!
Most insurance companies would look at the older of the two owners when determining whether a 10% penalty would apply. However, it's always best to check these types of things with the insurance companies themselves (because companies sometimes do things differently).
Please feel free to reach out with any additional questions.
- Kyle
Frederick B.
2023-01-04 06:53:40
I have a Non Qualified Annuity since 1995. Will I Need to do automatic distributions at age 70 or 72 years of age ?. Or are Non Qualified Annuities exempt from: RMD. Thank You... Please advise.
Kyle
2023-01-05 14:15:58
Hi Frederick,
Thank you for reaching out.
Non-qualified annuities do not have RMDs, so you are okay there.
Please let us know if you have any other questions. We'll be very happy to help.
Best regards,
Kyle
Frederick B.
2023-01-09 14:54:11
Thank you so much for getting back to me. My Question on Non Qualified Annuities was answered by you nice and detailed report.
Thank again !!! Frederick Belanger
Richard
2023-02-11 17:18:56
For a non-qualified fixed annuity during the annuitization phase and after age 59 ½, is part of the distributions non-taxable as a recovery of basis, and the remaining part taxable as ordinary income? If so, how is it determined (what formula) for each distribution, how much is a recovery of basis and how much is taxable? Is this determined on a year-by-year basis? What if I decide to take the full amount of the annuity over 3 years, or 5 years, etc.? Thanks in advance for your reply.
Kyle
2023-02-17 11:50:57
Hi Richard,
Yes. The return of your basis would be non-taxable and the remaining portion would be interest, and taxable as ordinary income.
If you're taking the income over a 5-year period as you suggest, the interest is distributed evenly across all 60 monthly payments. In other words, each payment contains the same ratio of principal and interest.
Best regards,
Kyle
Marie M Z.
2023-03-17 15:41:48
I have an athene non qualified annuity. The money came out of my savings. I have made my first withdrawal. I received a 1099R showing the full amount of the withdrawal I made as gross distribution and it also showed the full amount of my distribution as taxable amount. Confused
Kyle
2023-03-22 08:00:23
Hi Marie,
Thank you for reaching out.
When you take a withdrawal from an annuity, any earned interest will be withdrawn first, before your principal. This could be why the 1099-R is showing a fully taxable amount. I would recommend speaking with your agent, or with Athene to confirm that this is the case.
Best of luck!
- Kyle
Bill
2023-04-12 15:39:11
Started collecting Lifetime payments in 2022 on my annuity purchased 10 years ago. Company is treating my montly payment as a withdrawl with LIFO and saying it's all taxable. Why isn't it considered under the exclusion ratio and partially taxable? Who or what determines if I'm in the accumulation or ammortization phase and subject to LIFO or exclusion ratio?
Kyle
2023-04-13 13:23:48
Hi Bill,
Thank you for reaching out.
Based on your comments, it sounds like you're probably dealing with an indexed annuity and an income rider, as opposed to an annuitized contract (like a SPIA or DIA). If you have an income rider, your monthly income payments are treated like regular annuity withdrawals, and any accrued interest would be removed first (LIFO). This is unlike an annuitized contract where a portion of your payment would be principal and a portion would be interest.
I would recommend contacting either the insurance company, or your agent, for a clarification on the taxation.
Best of luck!
- Kyle (ImmediateAnnuities.com)
Mary S.
2023-05-15 06:18:37
My bank sold me 2 MYGA annuities (non-qualified),that are laddered 3 and 4 years with NY Life. He was unaware of the aggregation rule. If I read your article correctly, as long as I only withdrawal the interest on both policies annually, then only those amounts would be taxable. I do not plan to dip in any principal amount, just the gain on both. Thank Mary
Jeanne S D.
2023-05-19 08:34:05
What if one owner of an annuity is 69 and the other is 56, and the annuitant listed is the 69 year old? Are withdrawals still subject to a penalty?
Kyle
2023-05-19 10:37:06
Hi Jeanne,
Thank you for reaching out!
In this scenario - most companies will base the withdrawal on the age of the older annuitant for taxation purposes. However, we would always recommend confirming this with the insurance company prior to purchasing your annuity.
Best regards,
Kyle
Mjc
2023-06-14 08:55:15
Can I avoid the 10% early withdrawal penalty on a non-qualified annuity if I cash it out and purchase a similar non qualified annuity within 60days. I am unable to utilize the 1035 exchange rule due to a timing/rate issue. I'm under 59 1/2.
Kyle
2023-06-15 10:01:31
Hi MJC,
Unfortunately not. There is no 60-day option for 1035 exchanges like there is with transfers/rollovers. In order to be tax-deferred, the funds have to go DIRECTLY from one insurance company to another.
Best regards,
Kyle
Dave O.
2023-09-07 15:27:21
If I have a nonqualified annuity and then want to rollover just the taxable amount that I have earned can I do that and then withdraw what is left my base with no tax consequences
Kyle
2023-09-08 07:25:56
Hi Dave,
Thank you for reaching out.
No, unfortunately not. If you do a partial 1035-exchange to another annuity, equal parts principal and interest will be moved to the new company. It will not be only interest that gets moved. You'll still be left with interest in your existing annuity and that will be withdrawn first, before the remaining principal.
Additionally, you'll have issues if you take a withdrawal from either contract within 180 days of your partial 1035-exchange. Here is a helpful article from Principal Financial:
https://advisors.principal.com/wps/portal/advisor/resource-center/education-training/advanced-markets-info/annuities/annuities-advanced-markets-partial-1035-restrictions-distributions
We are not tax professionals, so we recommend reaching out to your tax professional for guidance with these matters.
Best regards,
Kyle
Todd
2023-10-11 14:03:37
My mother purchased an annuity in 2016 with a $70,000 death benefit from my father's life insurance policy. She has been taking an small annual distribution form the annuity to pay the taxes on her home. She took just enough to ensure that she did not eat into the original $70k. She passed away last year and my sister an I are the beneficiaries. If we each take the lump distribution, will we be taxed on that distribution? The annuity was purchased with non taxable life insurance. Thanks
Kyle
2023-10-12 13:12:50
Hi Todd,
Thank you for reaching out!
First, I'll preface this by stating that we are not tax professionals and we can not provide tax advice. We would recommend reaching out to the insurance company or a CPA for clarification.
That being said, if only the original $70k remains in the annuity you're inheriting, then you should not be taxed. You should only be taxed on any interest you receive.
Best of luck!
Best regards,
Kyle
Michael
2023-11-27 21:47:46
my mother will be 95 in february 2024. just received documents from holder of annuity. they want to know if my mother wants a lump sum payment or payments over time. its a 30 yr non-qualified annuity. what would be the best option for her? thank you.
Kyle
2023-11-29 11:23:42
Hi Michael,
Thank you for reaching out!
Let me preface this by saying that we are not tax professionals, so we cannot provide any tax advice. It would be best to work with an accountant to determine the best strategy.
Generally speaking - if your mom takes a lump sum then ALL of the interest earned up to this point will be taxable this year. If she elects to have it paid out to her over a number of years, then the tax obligation will be spread out over that amount of time.
It will be a matter of what the best fit is for your mom in her current situation.
Best regards,
Kyle
Mel
2024-03-21 17:10:12
excellent article
have a situation where a consultant started a consolidation of assets liquidating two fixed annuities in July. The process was drawn out because she went into assisted living and a POA was needed to complete the process. She died 9/1 - the proceeds weren't received and deposited) until 9/26 and 11/15. Should that be on her return or the her estate's / beneficiary?
Lisa
2024-06-26 14:48:33
I have an immediate income annuity. Am I able to take a lump sum from this at 59 1:2?
Kyle
2024-06-27 10:01:29
Hi Lisa,
Thank you for reaching out.
Unfortunately, this is something you'll need to speak directly with your insurance company or agent about. Some immediate annuities allow for lump-sum withdrawals, but many do not. You should also be sure to research any tax implications involved with taking a lump sum withdrawal, if available.
Best of luck!
Best regards,
Kyle
Tim
2024-08-13 19:12:01
I have several non-qualified fixed annuities that mature shortly after I reach 59-1/2. I want a strategy to withdraw funds from these annuities which will minimize my tax-burden on earned interest. My question is can I select a payout option that makes systematic withdrawals for each annuity over say a 5 year period? If I can use this option, is this considered a surrender or annuitization...and does LIFO apply to equally to both? I get confused with these terms and the implications in terms how the withdrawals are taxed. Thanks in advance!!
Kyle
2024-08-15 09:36:37
Hi Tim,
Thank you for reaching out!
What you are describing would be an annuitization for a "5 Year Period Certain" option. Interest would be distributed evenly across all sixty monthly payments, so "LIFO" would not apply here.
I would also add that you have no obligation to annuitize with your existing insurance company. You can compare their "5 Year Period Certain" quote to what you're able to get on the open market. If you obtain a better quote elsewhere, you can do a 1035-exchange to the new company.
We would be happy to help you with these annuities when the time comes. Please give us a call on our toll-free number, (800) 872-6684.
Best regards,
Kyle
Barney
2024-11-14 13:22:47
My father, upon his death, will will leave several non qualified annuities to his four children and his not for profit church. My question is, while I realize the gain will be taxable to the four children, is it a viable strategy to have the taxable portion (earnings) all allocated to the churches check so the kids only get the tax free portion.
Kyle
2024-11-14 13:29:53
Hi Barney,
Thank you for reaching out!
It's a good thought, but I do not believe that the insurance company (or companies) will be able to segment the taxable vs. non-taxable portions in this way. In our experience, each beneficiary would receive equal portions of taxable vs. non-taxable funds (aka interest vs. cost basis).
Best regards,
Kyle