Many investors nearing retirement usually become risk-averse, and annuities are a great choice and often beocome a valuable investment tool. Immediate annuities, though, sometimes get a bad rap because once you buy one, you generally can't get your principal back. However, this drawback has a silver lining: immediate annuities can provide an attractive tax break.

Your Gift From the IRS
When you buy a non-qualified immediate annuity, the income you receive is based on your age, your gender, and the amount of your purchase. As money is paid to you, it is divided into two buckets: interest and principal. The interest is taxed as ordinary income, but the principal is tax-free because it is a return of your initial investment, assuming it was submitted with after-tax funds. The amount of principal returned in each payment is determined by the same factors that the annuity company uses to calculate how much income you'll receive; it assumes that the principal will be returned to you equally over the payout period.

When you request a quote from an annuity company, it will provide an illustration that shows the percentage of each payment that is tax free. In the following example, we'll take a look at the tax implications for a 65-year-old female in Pennsylvania, who wants a lifetime income from her $100,000 purchase.

Investment Amount $100,000
Payout Period Lifetime (18 years as per IRS)
Annual Payment $7,644
Total Payments over Life Expectancy (18 years) $137,592
Exclusion Ratio 72.7%

Note: The exclusion ratio = investment amount divided by the total payments
$100,000 / $137,592 = 72.7%

This means that $5,557.19 ($7,644 x 72.7%) of each annual payment is a tax-free return of principal, which leaves only $2,086.81 as taxable income. Payments received after 18 years will have fully taxable interest because there is no more principal to return. You can find additional information, including worksheets and tables, in IRS Publication 939.

Let's Compare
Now you need to translate that into a taxable-equivalent cash flow so you can compare an immediate annuity's cash flow to a taxable investment's before-tax return.

Assume, as in the above example, that you will receive $5,557.19 tax-free and you are in the 25% tax bracket. That's like getting $7,409.59 ($5,557.19 / 0.75) before paying taxes. You would add that to the taxable amount of the immediate annuity that you also receive and get:


The total before-tax equivalent cash flow becomes:

$9,496.40/$100,000 = 9.50% per year

Unless you buy some additional options on your annuity, once you die, the income stops and your heirs get nothing. Nevertheless, if a steady income is your main goal, it's hard to beat an immediate annuity when you stack it up against Treasury bonds, AAA munis or high-grade corporate bonds.

Easing the Tax Bite
Many people are not even aware of the possible income tax on their Social Security benefits. The tax on Social Security benefits depends on your total income and marital status. Form SSA-1099, which Social Security recipients should receive by January 31, shows the recipient's total benefits. To determine how much tax you will owe, add one-half of your Social Security benefits to all other income, including tax-exempt interest. If this amount is greater than the base amount for the filing status, a part of the benefits will be taxable.

The base amounts that will cause 50% of the benefits to become taxable are:

But, according to the IRS, up to 85% of the benefits can be taxable if either of the following situations applies:

  • The total of one-half of the benefits and all other income is more than $34,000 ($44,000 if married filing jointly).
  • You are married, filing separately and lived with your spouse at any time during the year.

For additional information on the taxability of Social Security benefits, see IRS Publication 915.

Annuities can help reduce the federal income tax on your Social Security income even more than investing in tax-free municipal bonds.

The following is a continuation of the above hypothetical example of a single female taking the standard tax deduction. Let's assume she has $100,000 to invest, that the corporate bonds and tax-free bonds each pay 5% interest, and the immediate annuity has the same payout as shown earlier.

- Scenario No.1 Scenario No.2 Scenario No.3
- Corp. Bond Interest Tax-Free Interest Imm. Annuity Interest
Interest from Bond Investment $5,000 $5,000 $2,087
Pension $25,000 $25,000 $25,000
Social Security $10,000 $10,000 $10,000
Non-Taxed Income -- -- $5,557
Total Income $40,000 $40,000 $42,644
Social Security Subject to Tax $5,350 $5,350 $3,544
Gross Income $35,350 $30,350 $30,631
Total Federal Tax $3,524 $2,774 $2,811
Net income $36,476 $37,226 $39,833
Source: Tax computations by Turbo Tax™ 2005 1040 software, using 2006 tax rates.

Compared to the corporate bond, the immediate annuity will reduce her federal tax by $713 and increase her income by $3,357 each year. And even though the income tax is $37 less with the tax-free bond, her net income is $2,607 more with the immediate annuity!

Who Should Consider an Immediate Annuity?
The following checklist should help you understand the risks associated with annuities, and whether an immediate annuity may be right for you:

  • Do you have anyone who depends on you financially? If so, you might not want an immediate annuity that stops paying when you die. A payout plan that will continue to a survivor could be a better choice.
  • Do you have a long life expectancy? Annuity companies estimate how long they'll have to pay you before you die. The longer you live, the better chance of getting more money than you put in.
  • Do you have other liquid assets? In many cases, money you put into an annuity can't be touched, so be sure you have other funds that you can get to so you don't end up in a bind. These could include bank accounts, mutual funds or stocks.
  • Will the annuity's exclusion ratio lower your taxes? Check your 1040 to see whether you might even drop down to a lower bracket or reduce the amount of Social Security income that will be taxable.
  • Do you own bond mutual funds? When interest rates rise, bond funds can lose value. And when interest rates fall, your income drops. You don't have to worry about either of those outcomes with an immediate annuity.

When This Loophole Fails
You can purchase an immediate annuity with a traditional IRA or other tax-qualified retirement plan, but you've probably never paid tax on those funds. Therefore, money coming out of such accounts is fully taxable, and the exclusion ratio won't apply.

The Bottom Line
Tax savings should be an important consideration when comparing investments. In the case of immediate annuities, you may find that after-tax return could be greater than what is available from other conservative fixed-income investments. In addition, you can get an income that you can't outlive.

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