1. 37376 POINTS
    David G. Pipes, CLU®, RICP®
    Business Development Officer, T.D. McNeil Insurance Services, Fresno, California
    The good news is that annuity income is usually reported by the insurance company issuing the annuity. When they make a disbursement they also issue appropriate documentation to assist in filing your taxes. They send identical information to the Internal Revenue Service.

    Generally speaking when money is withdrawn from an annuity it is treated as interest and then taxed as ordinary income until the interest is exhausted and only the basis (the sum of premiums paid) remains. That money can be recovered free of income tax. If the annuity is “annuitized,” that is paid out in monthly installments either over an extended period of time or the lifetime of the annuitant, then an exclusion factor is determined and applied to each payment. A part of each payment will be taxed as ordinary income.

    The bad news is that these principles apply to “non-qualified” annuities held by individuals and these barely touch all the situations that can arise and the taxation of those unique situations. While this response is not meant to take the place of legal and accounting professional advice it should alert you to some of the complexities of taxing annuities.

    The most obvious situation is when an annuity is held as an asset of qualified pension plan. This includes defined benefit plans; defined contribution plans (401(k), IRAs and many others. The income taken by these plans is taxed as ordinary income unless it is taken prior to age fifty-nine and a half. If taken earlier it could be subject to a penalty tax of an additional ten per cent.

    Where annuities taxation becomes complex is when deferred annuities are transferred. That is when a person gives another person an annuity on their life, or the life of a third party. The basic rule is that the transfer is treated as surrender and taxed accordingly. The annuity that is transferred is treated as having been fully paid. It then has a basis of the value that was taxed.

    For estate planning reasons the ownership of an annuity is sometimes held by a trust and this leads to another set of taxation considerations involving the “non-natural” person rule. Who is going to be taxed is the basic issue and this can be quite tangled. Of course there are exceptions to all of these rules.

    Taxation is fairly straightforward if the annuity is annuitized.

    State laws concerning probate can create some unexpected outcomes and taxation. When an individual owns an annuity and the annuitant is another person, perhaps a spouse, the death of the owner triggers the beneficiary provision and another third person could suddenly own the contract upsetting the intentions of the couple, even if it is a child.

    Many of the taxation rules are specific to individual insurance companies and it is wise to carefully make sure that the company you select from whom to purchase the annuity follows the procedures that will maintain your plan and keep taxation as uncomplicated as possible.
    Absent all other plans, the IRS frequently calls for a liquidation of a transferred annuity within five years. The key is the desire to get the tax question settled.
    Answered on October 15, 2014
  2. 5082 POINTS
    J Paul Wilson CFP, CHFC
    Certified Financial Planner, JPW Insurance Retirement Investments, Halifax, Nova Scotia, Canada
    In Canada, immediate and deferred annuities are, with one exception, taxed on an accrual basis. The growth or income is taxed as earned, not as received. How the income is taxed, depends, if it is interest income or, in the case of Guaranteed Investment Fund (GIFs), interest, dividends or capital gains.

    Prescribed Annuities enjoy special taxation (Section 304 of Income Tax Act). They are taxed on a straight line basis rather than on an accrual basis. If you qualify for a prescribed annuity then total amount of "expected" interest is averaged based on the number of payments.

    For example invest in a prescribed life income annuity and your "life expectancy" is 22 years.

    The amount of investment DIVIDED BY "life expectancy" EQUALS return of your principle and it is not taxed.
    The annuity payment SUBTRACT the return of your principle is taxable.

    The tax savings can be substantial, which is why prescribed annuities are often used to increase after tax income. Especially for those who prefer guaranteed interest income. A life insurance policy can replace the capital for your estate. Depending on the the individual circumstances, increases of after tax income can be 50% or more.

    Implementing a strategy involving payout annuities is sometimes complicated, it is however, always permanent. Search for Retirement / Financial planner in your area. Then look for an experienced life insurance broker with a professional designation such as a CLU or CFP.

    If you have further questions, or feel that I could be of assistance please contact me.
    Answered on January 21, 2016
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