Withdrawals from an annuity are subject to ordinary income taxes on earnings. A minimum account value is usually required to qualify for certain withdrawal options. The insurance company may also require a minimum distribution amount and will usually allow only a certain number of withdrawals per year.
Withdrawals are deducted from sub-accounts as a percentage based on the proportional amount allocated to each account, unless the policyholder specifies otherwise. For example, if the annuitant has 23% in Sub-account X and 77% in Sub-account Y, withdrawal amounts will reflect this percentage, albeit at much lesser amounts.
Lump sum annuity withdrawals are taxed on a last in, first out (LIFO) basis, so earnings are withdrawn first and taxed as ordinary income, while any amount in excess of earnings is taken from the principal amount and is nontaxable. However, annuitized payouts are taxed differently:
- Each payment is considered one part principal (non-taxable) and one part rate of interest (taxable).
- Each payment is adjusted by an exclusion ratio, which is a ratio that describes the relationship between the invested amount and the total expected return under the annuity contract.
As mentioned earlier, the annuitant can typically transfer money from one investment option to another during the accumulation phase without paying tax on the investment income and gains (although certain insurance companies may charge for the transfers). However, if the investor withdraws money from the account during the early years of the accumulation phase, he or she may have to pay surrender charges (discussed below). In addition, the investor will have to pay a 10% federal tax penalty on earnings if the money is withdrawn before the age of 59.5 unless the withdrawal qualifies for an exemption, such as withdrawals due to death, disability or those made in substantially equally payments (SEPPs) based on the owner's life expectancy.
Variable annuities sometimes offer other optional features, which also have extra charges. One common feature, the guaranteed minimum income benefit, guarantees a particular minimum level of annuity payments, even if your client does not have enough money in his or her account - because of investment losses, for instance - to support the level of payments. Other features may include long-term care insurance, which pays for home healthcare or nursing home care if the investor becomes seriously ill.
Variable Annuity Charges
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