As April 15 draws near, many of your clients may face uncertainty about whether they should claim various investment income on their taxes and, if so, how. This is especially true in light of recent tax code changes signed into law — the first major revisions since 1986.1
Retirees who rely on income from tax-deferred annuities may be affected by changes to tax rates, brackets, deductions, and exemptions. Here, we’ll share a general overview of how qualified and non-qualified annuities are taxed along with some considerations for helping your clients to manage their investments.
Annuities are Tax-deferred, Not Tax-free
Misconceptions about annuities aren’t uncommon. While some annuities are often promoted as being tax-deferred, it should never be implied that these investments are a way for retirees to avoid paying taxes all together. Once an investor begins withdrawing earnings or lump sum distributions from an annuity, a portion of those withdrawals will be taxed as regular income based on how the annuity was structured to begin with.
Investment gains on fixed or variable annuities over and above the initial contributions must be withdrawn first, and those earnings are considered taxable income. Once investors begin withdrawing from their cost basis, the income is generally not considered taxable.2 Qualified and non-qualified annuity payouts are taxed differently, however.
Qualified Annuity Taxes
Qualified annuities are funded with money that hasn’t been taxed prior to placing it in the investment (pre-tax). Your clients can choose to deposit or rollover a tax-deferred 401(k) or IRA directly into a qualified annuity, for example. Because these contributions weren’t taxed to begin with, however, they will be fully subject to the owner’s ordinary income tax rate (rather than the capital gains rate) upon withdrawal in addition to taxes on any subsequent earnings.3
Non-Qualified Annuity Taxes
Owners of non-qualified annuities that are funded with after-tax contributions will owe income tax on only a portion of their withdrawals because the initial principal used to fund the account is considered a return of capital that was already taxed.
There may be a caveat, however, as returns above the exclusion ratio — a special computation based on dividing the principal paid by the expected return — on a non-qualified annuity are typically subject to taxes, including capital gains.3
Fixed vs. Variable Annuity Taxes
If your client has a fixed annuity, distributions are based on your client’s life expectancy. If he or she lives longer than that, however, all money withdrawn during the time beyond their originally anticipated life expectancy may be subject to taxation. The payment schedules for variable annuities aren’t quite as predictable and work differently because of their exposure to the marketplace.3
Are Annuity Fees Deductible?
Prior to 2018, annuity investors could include user fees as miscellaneous itemized deductions that were subject to a 2 percent AGI limit. The Tax Cuts and Jobs Act (TCJA) under the current administration suspended miscellaneous itemized deductions for tax years 2018 through 2025. Deductions for user fees will not be allowed until after 2025.4
As the saying goes, only two things in life are certain: death and taxes. While paying taxes is certainly unavoidable, you can help your clients plan a strategy that allows them to keep more of their savings. Annuities continue to be an important part of an investment portfolio, especially for those who are highly risk-averse and want a form of guaranteed income in retirement with downside protection and upside potential.
Tax rules can be just as varied as the types of annuities and structures available. For example, you may want to check out the comparison between buffer versus floor annuities in our helpful guide below. No matter which types of annuities your clients choose, encourage them to work with a reputable tax advisor to determine their unique needs.
1Reuters, New U.S. Tax Law Could Create Underpayment Headaches for Retirees, September 21, 2018
2The Balance, How to Estimate Taxes in Retirement, October 31, 2018
3CNN Money, Before Choosing an Annuity, Know the Tax Implications, May 11, 2018
4IRS, Publication 939 (12/2018), General Rule for Pensions and Annuities, December 2018