Taxation of Annuities During the Accumulation Period

Income earned by a variable annuity (see Questions and Answers below) is not taxed during the accumulation period. No tax will be payable until the earlier of: (a) the surrender of the contract; (b) a withdrawal from the contract; or (c) the time payments under the annuity begin (annuitization). To obtain annuity treatment, however, the underlying investments of the segregated asset account must be adequately diversified according to IRS regulations.

Payments made as an annuity under a variable annuity are not subject to the same exclusion ratio as is a regular fixed annuity. This is because it is impossible to determine the expected return. Instead, the following formula is used:

If there is a period certain or refund guarantee, the investment in the contract is adjusted accordingly. If payments are made for a fixed number of years without regard to life expectancy, the divisor is that fixed number of years. If payments are made for a single life, use IRS Table V. If payments are to be made on a joint and survivor basis, use Table VI. As in the case of a fixed annuitization, the exclusion ratio no longer applies once an annuitant reaches his life expectancy and has fully recovered his investment in the contract.

If payments drop below the excludable amount in any given year, the annuitant can elect to redetermine the excludable amount in the next tax year in which he receives an annuity payment. The loss in exclusions is divided by the number of years remaining (in the case of a fixed period annuity). In the case of a life annuity the loss is divided by the annuitant’s life expectancy computed as of the first day of the first period for which an amount is received as an annuity.

Example. Assume a sixty-five-year-old taxpayer purchased an annuity for $20,000. The contract provides variable monthly payments for life. Because his life expectancy is twenty years (Table V), he may exclude $1,000 of each annuity payment from income ($20,000/20). Assume on his seventieth birthday he receives only $200, $800 less than his excludable amount. At age seventy, his life expectancy is sixteen years. He may elect to add $50 ($800/16) to his $1,000 exclusion, a total of $1,050 which he may exclude that year and in subsequent years.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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