An annuity is a tax-deferred instrument in which distribution taken during Accumulation and Income phases is taxed differently. Funding source and age also affects taxes.
Annuities allow for two ways to take money out of the policy: withdrawals and income. A withdrawal is ad-hoc removal of funds as a lumpsum from the Cash Value (CV) account. The income, on the other hand, is a structured payout whose initial value is calculated using the Income Value (IV) account. The income is either received for a set number of years (called Period Certain) or for the life of the insured. These and other income options are discussed in “Annuity Product Types.” Annuitization is the process of starting income. The tax implications are varied and are based on the funding source, age and the distribution type (withdrawal or income).
Roth IRA (Post-Tax bucket): When funded from a Roth IRA, the annuity income or withdrawal is tax-free provided the distribution is qualified, i.e., insured is 59.5 or older and the account is open for 5 years or longer.
Traditional IRA (Pre-Tax bucket): When funded from a Traditional IRA, the annuity income or withdrawal is fully taxed when taken as a qualified distribution (age 59.5 or older). Non-qualified distribution is subject to tax plus a 10% penalty.
The penalty, however, can be avoided if the distribution is less than the 72(t) limit and taken on an ongoing basis until age 59.5 is reached or for 5 years, whichever is longer. The 72(t) limit is calculated using one of several methods defined in the tax code and it typically works out to ≈3-5% of the account value. The tax laws around 72(t) distribution are explained in our blog “How to Move Asset Between Tax Buckets.”
Non-Retirement (Taxable bucket): When funded from a regular bank account, the principal grows tax-deferred, and when a distribution is taken, only the interest (growth portion) is taxable. The taxable portion is calculated using a LIFO (Last In First Out) accounting method. It stipulates that the earnings be taxed before the principal. The additional 10% tax penalty still applies when a distribution is taken before reaching age 59.5, but this penalty can be avoided if the distribution satisfies 72(t) rules.
When drawing income, the insurance company can apply LIFO rules in one of two ways. All initial income can be treated as earnings and taxed fully, until the earning portion of the account value is exhausted. After that, the income stream will be considered as the return of principal and will become tax-free. Alternatively, an exclusion ratio can be used to calculate the tax-free principal and taxable interest portion of every income check. Exclusion ratio is the principal amount over potential lifetime income, which is calculated based on one’s age.
Detailed account characteristics of the different tax buckets are described in “Tax Treatment of Investment and Retirement Accounts.”
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