How Much Tax Will I Owe on My Secondary Market Annuity?

Written by Hersh Stern Updated Sunday, November 3, 2024

The topic of retirement planning would not be complete without taking a look at how a secondary market annuity would affect your taxes. My clients ask about this all the time, and they should!

As you well know from a lifetime of working, income taxes can make a real impact on your monthly budget, so no plan would be complete without factoring in this important detail.

The way income from a secondary market annuity is taxed is quite different from many other investments and, even, other annuities. In fact, the tax burden can be much lighter than dividend distributions from stocks or bonds.

When you buy a secondary market annuity with after-tax savings, the government recognizes that that money has had taxes already paid on it. For this reason, as you receive each month's income from the annuity, you are only taxed on that portion of each payment which represents new earnings: meaning, the new interest your annuity is generating (above the principal you receive). Notably, you are not taxed a second time on that portion which represents a return of your previously-taxed principal.

This method of calculating annuity taxes is called the "exclusion ratio" or "pro rata" method. In other words, the IRS determines how much of your regular income is excluded from being counted as taxable income based on the percentage of the total income you receive which is considered to be after-tax principal.

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The bottom line is that the IRS allows you to amortize the interest that you are receiving from a secondary market annuity over time, significantly reducing the upfront tax burden that might occur from other types of investments, including deferred and indexed annuities.

Keep in mind that you will not receive a 1099 from any insurance company when you purchase a secondary market annuity. Therefore, tax reporting becomes your responsibility. You should consult your accountant to ask for tax advice and to help you understand this piece of annuity-buying strategy.

This discussion would not apply, however, if you buy your secondary market annuity with Traditional IRA or 401k dollars. To buy your annuity with these types of tax qualified monies, you must first set up a self-directed IRA account. When completing this transaction type using qualified funds, it is essential that it is conducted properly in order to maintain IRA status.

The payments from your SMA will be directed back into your self-directed IRA and will maintain tax-qualified status until they have been withdrawn. When you choose to withdraw funds from your self-directed IRA account, they will be 100% taxable as ordinary income.

A self-directed IRA can also be used to purchase an SMA with Roth IRA funds. In this case, payments from your SMA will be made back into your Roth IRA and will maintain the same tax status. When you choose to withdraw funds from your Roth IRA, the income will be completely tax-free, which is true for any withdrawals from a Roth IRA.

With all tax matters, of course, this is a guide. I encourage all my clients to consult with their accountants to review the ways in which an annuity purchase would affect their financial situation.