Where Annuities Are Vulnerable to Income Taxation

Annuities and cash value life insurance have a tax advantage in common; their earnings grow tax-deferred. But that's where similarities end. Because an annuity is geared to be used while the owner is living, any of its earnings that come out of the contract will be subject to income tax. Here's when that occurs...

All annuities have two phases: an accumulation phase where your contributions grow tax-deferred, and an annuitization phase where you receive your payouts usually in monthly installments.

During annuitization, you're monthly payouts are considered as made up of both a contribution part (from your premiums you paid) and an earnings part from investments supplied by the annuity company. The contribution part is not taxed because it's a return of your basis in the contract - the total premiums you paid. But the earnings part is taxed as income. After you've received all your contributions back with the payments you've received, then all future payouts are fully taxed as income.

During the time you're contributing to your (deferred) annuity, the earnings are growing tax-deferred. But what if you want to pull some money out - like take a loan from your annuity?

*Loan or withdrawal:

Sorry, there are no loans for annuities (only from cash value life insurance policies)! Taking money out of your deferred annuity is a withdrawal; and earnings are considered to come out first. That means what you take out will be fully taxed as income until you pull out all the earnings and start pulling out your contributions - i.e. your basis in the annuity contract. If you're under 59 years old, the IRS imposes a 10% penalty tax on everything you take out in addition to the income tax on it.

*Gifts:

If you make a gift of a deferred annuity to a person, charity or a charitable remainder trust, the gift will also trigger an income tax on the annuity's earnings. And yes, that 10% penalty tax is imposed too if you're under 59.

Also the deduction you can claim for a gift to an approved charity is limited to the giver's basis- (i.e. his total premium contributions to the annuity) which can be far less than the annuity's cash value if earnings have grown it over a long period.

*Cashing Out:

Since the earnings of your annuity will eventually come out as taxable income, you may decide to just 'cashout' if you think that a deferred annuity is not the right investment for you. And you'd rather invest your money so its growth will be taxed at lower rates - such as long term capital gains or otherwise in an alternative investment type.

If so, you might want to take advantage of a current low tax bracket to cashout. If you're money has not been in the annuity very long, there may be relatively little earnings to be taxed.

Remember that annuities once annuitized cannot be surrendered for value - at least from that annuity company. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 1/2 are subject to a 10% penalty. Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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