Wednesday, May 23, 2012

Tax Treatment of Annuities

Annuities – Part Gain and Part Return on Capital

An annuity provides, in exchange for one or more payments by or on behalf of the beneficiary (annuitant), a stream of equal periodic payments for the life of the annuitant, thus protecting the annuitant against the risk of depleting her savings by outliving her life expectancy.

Understanding the tax treatments of annuities is important. Instead of a basis-first rule, Congress has provided for gradual recovery of an annuitant’s basis, according to the exclusion ratio of § 72(b)(1). OPPOSITE OF INSTALLMENT SALES METHOD.

 Under the statutory approach, the portion of an annuity payment treated as a tax-free recovery of basis “bears the same ration to the amount of the annuity payment as the invest in the contract (as of the annuity start date) bears to the expected return under the contract (as of such date).

Nontaxable amount = annuity payment * (investment in the contract/expected return)2.    PRODUCES AMOUNT EXCLUDED FROM GROSS INCOME.

§ 72(c)(1) says that the investment in the contract equals the premiums paid reduced by any amounts received before the annuity starting date and excluded from her income.

§ 72(c)(1) also says that if the expected return on an annuity depends on the annuitant’s life expectancy, the expected return shall be based on actuarial tables prescribed by the treasury. If someone gets an annuity before it starts to pay out, it is treated as tax-free unrealized appreciation on the gains of the investment.

§ 72  offers two significant tax advantages to owners of annuities:

1.    The deferral of tax on the increase in the value of the annuity during the period before payments begin
2.    The understatement of the income portion of payments in the early years is beneficial.

 If someone dies early, the undeclared portion left on their annuity can pass through to the estate and the heirs can claim it. However, remember if you convert life insurance into an annuity, you will be taxed and there is no tax free death benefit. Overall, annuities can have significant tax benefits.

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