Lump Sum Distributions
If the annuitant surrenders the contract and receives a lump sum distribution, any gain over the annuity principal is taxed as ordinary income in the year received. As demonstrated by the following example, this can substantially reduce the amount available to the annuitant to meet wealth accumulation or retirement income needs.
$200,000 Annuity Surrender Value
- 40,000 Annuity Principal
$160,000 Gain
x .28
Tax Bracket
$ 44,800 Income Tax Payable
It is usually advantageous to annuitize the contract, spreading income tax payments over years.
Annuity Distributions
The basic tax rule applied to annuity distributions is designed to return the annuitant's principal or investment in the contract in equal tax-free amounts over the payment period. Any additional amount is then taxed as ordinary income. This means that a portion of each annuity payment is received tax-free, while the balance is taxable. This serves to spread the annuitant's income tax liability over a period of years.
A formula called the exclusion ratio is used to determine the non-taxable portion of each payment. The exclusion ratio is equal to:
Expected Return
The investment in contract is the amount paid for the annuity (single premium or total periodic premiums). Expected return is the total amount the annuitant can expect to receive from the contract. If one of the life or joint and survivor life annuity options is selected, expected return is equal to one year's annuity payments multiplied by the life expectancy of the annuitant (or annuitants).
Let's assume that an annuitant with a life expectancy of 17.2 years receives $1,200 per month ($14,400 a year) from an annuity with a $100,000 purchase payment. The exclusion ratio would be:
$100,000 Investment in Contract = .40 Exclusion Ratio
$247,680 Expected Return ($14,400 x 17.2)
This means that 40% of each $1,200 monthly payment, or $480, is received tax-free and the remaining 60%, or $720, is taxed as ordinary income.
If the annuity payments end with the annuitant's death, no value is included in the annuity owner's gross estate. Any unpaid amounts guaranteed by a period certain or installment refund annuity option, however, must be included in the deceased owner's gross estate for estate tax purposes. The beneficiary will have to pay income tax to the extent that the amount received by the beneficiary, when added to the tax-free amounts received by the annuitant, exceeds the annuity's purchase price (investment in contract).
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