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Annuity Tax Benefits
Legal Tax Angles:
How to Save Taxes Without Going to Jail
An annuity is a source of tax deferred income that can last as long as you live. It's
usually issued by a life insurance company in exchange for a single payment
or series of payments.
For example, you might give an insurance company $50,000 at age 70 and the
insurance company agrees to pay you $350 a month for the rest of your life.
(Based on female life expectancy). That's an annual payout rate of 8.4% --
but it includes a return of your initial $50,000 deposit plus some interest.
Based on a 20 year life expectancy, that represents a 5.7% rate of return
on investment, plus the return of part of your initial deposit.
If you could earn 8.4% on your savings, the annuity would not be a good deal.
But in the middle of 2002, a conservative return on your investment would
be more like 3% to 4%.
At age 70, a female who is age 65 can expect to live another 20 years --
on average. At age 70, the life expectancy is about 16 years. If you divide
the $50,000 by 16 years and then by 12 to compute the monthly amount, you
could consume $260 a month even if the investment generated no income at
all.
But -- if you live past age 86 (in this example), your money is gone. With
the insured annuity, you continue to receive payments no matter how long
you might live. With nearly daily medical breakthroughs, an increasing number
of people can expect to live beyond their computed life expectancies
-- which are based on historic averages.
If the annuity is from a pension plan, retirement savings plan, 401(k) or
IRA to which you or your employer have deducted the contributions, then the
payments you receive will be fully taxable.
But if you buy the annuity with your after tax investment assets, part of
the payments that you receive represents income and part of the payments
are a return of your initial investment. For tax purposes, the return of
your investment is not taxable.
But this presents a problem. How do you compute the portion of each payment
that is a return of capital and the portion that is income? It's made even
more difficult because the portions change with each payment. It's a lot
like the interest calculation on a home loan. With each home loan or annuity
payment, the principal payment increases and the interest payment decreases
with each payment.
To simplify this potentially complicated calculation, the IRS has come up
with an averaging system based on the total of the expected payments over
your life expectancy and the amount you paid for the annuity.
For example, if you are age 70 and you paid $50,000 for an annuity that will
pay you $350 a month for the rest of your life, the IRS says you can expect
to receive a total of $67,200 over a 16 year life expectancy. (They use unisex
tables.) The taxable part of your total payments would be $17,200 and the
rest of the payments is a return of your $50,000 investment. To compute the
percentage of each payment that is taxable, you need to divide the income
of $17,200 by the total payments of $67,200. The result is 25.6%. Thus, 25.6%
of each $350 payment would be taxable. For a year, 25.6% of the $4,200 of
payments would be $1,075. The remaining $3,125 is not taxable.
Information about the IRS annuity tables for life expectancies is available
in their annual tax guide (Publication 17) which you can get in printed form
from most IRS offices or from the Internet at www.irs.gov. More specific
information about the tax treatment of annuities is available in IRS Publication
939 which is available on the Internet. You can also get this information
from bookstores that carry the J.K. Lasser annual Your Income Tax"
or the Ernst and Young (annual) Tax Guide.
Some additional Internet information sources are
shown below.
An excellent introduction to annuities
http://www.newyorklife.com/NYL2/Group/0,1232,10468,00.html
Free online annuity calculator
http://www.immediateannuity.com/rates.asp
Life expectancy information
http://www.cdc.gov/nchs/fastats/lifexpec.htm
Mortgage loan calculator (used to compute
rate of return on investment)
http://www.bankrate.com/brm/mortgage-advisers/mortgage-calculator.asp
IRS Publication 939 - General Rule on Annuity
Payments
http://www.irs.gov/publications/p939/index.html
Vern Jacobs
Copyright, 2003
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Caution:
While the information in this web site is believed to be from
reliable sources and is believed to be accurate, it is not intended to
represent legal, tax or financial advice for any reader of any part of
this web site. Due to frequent changes in the laws, new court cases
and differences of opinion among professional advisors, readers should
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