Any investment income earned on annuities during the accumulation period is not taxable until distributed to the policyholder with one major exception.

If an annuity contract is held by an entity who is not a natural person (corporation or trust), the annuity taxation rules differ. The income on the contract must be treated as ordinary income received or accrued by the policyholder that year. Annuity benefit payments are a combination of principal and interest. Each payment is considered a partial return of basis and partially taxable income using an inclusion/exclusion ratio
.
a. Exclusion ratio - The numerator for the exclusion ratio is the cost basis in the annuity. The denominator is the total expected benefits.
b. Inclusion ratio - The numerator for the inclusion ratio is the total expected benefit less the cost basis. The denominator is the total expected benefits.

Example: John retired on December 31, 2004, and receives a monthly annuity pension benefit of $1,000 payable for life. His life expectancy at the date of retirement is 10 years. During his years of employment, John contributed $30,000 to the cost of his company's pension plan.

Solution: Excluded from John's taxable income in 2005 is $3,000 ($30,000 ÷ $120,000 = .25 or 25% 2005 (12 payments x $1,000) x ¼ = $3,000.

Practice Question:
Tom purchased a single premium immediate annuity for $100,000 lump sum for his life. Tom will receive a 4% return on his investment for the life of the contract. The insurance company has guaranteed Tom a monthly payment of $1,200 for the rest of his life. According to actuarial tables, Tom is expected to live another 10 years (120 payments). Which of the following is correct?

A. If Tom dies after receiving only $75,000 back, his beneficiary will not be taxed on the $25,000 return of premium.
B. If Tom lives longer than 10 years, all amounts received after the 120th payment must be included in his gross income.
C. If Tom collects $12,000 in his first calendar year from the annuity, the full payment will be considered a return of principal and not taxable income to Tom.
D. Tom's first monthly payment for $1,200 will have an exclusion ratio of 96%.

Answer: B
When Tom purchases a single-life immediate annuity, the insurance company will guarantee payments for Tom's life only, so payments will cease at his death. Tom's exclusion ratio will be 69.44% ($100,000 divided by $144,000), so a payment for $1,200 will have $833.33 excluded from gross income. If Tom lives longer than his 120th payment, all future payments will be includable as gross income. The 4% return is irrelevant for this question.



Introduction

Related Articles
  1. Retirement

    Are Annuities Retirement-Only Investments?

    Learn more about why annuities are generally purchased and the way that they can positively and negatively affect an individual preparing for retirement.
  2. Retirement

    How a Fixed Annuity Works After Retirement

    These popular investments can provide a steady stream of income during your retirement years. Here are the details.
  3. Financial Advisor

    An Overview Of Annuities

    These contracts provide a guaranteed income stream. Learn how they work and their benefits.
  4. Financial Advisor

    Advising FAs: Explaining Annuities to a Client

    Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
  5. Retirement

    Annuities Vs. Bonds: Which One Is Better For You?

    Compare the important features of annuities and bonds, and understand which investment vehicle is the better choice based on retirement goals.
  6. Retirement

    Why Are Annuities Important for Retirement?

    Understand how annuities work, and identify the benefits they provide for retirement, the most salient being a guaranteed income stream for life.
  7. Retirement

    When Annuities Are the Wrong Investment

    Understand how annuities provide several unique benefits, but many drawbacks as well, and identify the situations where they are not the best investment.
  8. Retirement

    How Are Variable Annuities Taxed?

    Before investing in a variable annuity, discuss your personal financial picture with a knowledgeable financial advisor.
  9. Retirement

    What Is the Best Age to Get an Annuity?

    Optimizing the benefits of an annuity means guaranteeing a stream of income you can't outlive.
  10. Financial Advisor

    Annuities: The Good, Bad and the Ugly

    Annuities suffer from a few perception problems. This primer that covers the good, the bad and the ugly of annuities.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center