A Brief Primer on the Taxation of Annuities

The taxation of annuities is governed by Internal Revenue Code section 72. Annuities grow tax deferred during the accumulation phase, although withdrawals during this phase are taxed on a Last In, First Out (LIFO) basis—meaning that withdrawals during the accumulation phase are considered to be withdrawals of growth first (fully taxable) and principal second. Payouts during the annuitization phase are split: a portion of each payment is considered principal, and a portion is deemed interest/growth. Insurers determine the proportions of each payment that is principal and interest/growth at the annuity’s beginning payment date. They determine these proportions based upon the already accumulated growth, an assumed internal growth factor for the payout period, and the expected length of the payout period. All amounts distributed that are considered interest/growth are taxed as ordinary income, regardless of the phase or timing of the withdrawal. In addition, certain withdrawals before the age of 59½ may be subject to an additional 10 percent tax penalty.

Although investors may find the tax-deferral feature of annuities to be quite advantageous, the primary reason investors should consider purchasing annuities is for their risk management features. Annuities can provide a variety of guarantees, whether protecting against interest rate risk, reinvestment risk, superannuation (living too long, such as outliving one’s assets), or certain market volatility risks. Annuities are first and foremost a risk management tool.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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