Learning Center

Annuities (P2)




How much of the periodic payment is taxable on a non-qualified immediate annuity?
On a non-qualified annuity only, each payment is part nontaxable return of principal and part taxable interest income. In order to determine what percentage of the monthly payment is nontaxable, the Exclusion Ratio must be applied. The Exclusion Ratio for each individual annuity is the ratio of the total investment to the total expected return. For example, if the investment in the annuity is $12,650 and the expected return is $16,000, the Exclusion Ratio is $12,650 divided by $16,000 — which equals 79.1% (rounded to the nearest tenth of a percent). Hence, if the monthly payment is $100, the portion that is nontaxable is $79.10 (79.1% of $100), and only $20.90 a month is taxable.

Who should consider buying an immediate annuity?
Immediate annuities are commonly used for individuals who have already retired and need annuity income right away. This type of annuity is also commonly used for an individual who is concerned about outliving his or her income, because if an annuitant chooses a “Life” settlement option, the income payments are guaranteed to continue as long as he or she lives — even if the annuitant outlives his or her life expectancy.

What are some other benefits of an immediate annuity?
In addition to the feeling of security that comes from knowing you cannot outlive your income, there are many other reasons to purchase an immediate annuity. First of all, immediate annuities offer simplicity because you do not have to manage your investment or even watch the market, and the payments can be deposited directly into your banking account. Annuities also offer an additional tax benefit on investments that are non-qualified because part of each check is a nontaxable return of your original investment, which results in lower annual income taxes.

What is a deferred annuity?
A “deferred” annuity is one that defers or postpones the payment or income options until a future point in time after purchase, as opposed to an immediate annuity, which starts the payments right away or at least within one year of purchase. “Deferred” can also mean “tax-deferred,” which means postponing your taxes on interest earnings until a future point in time. This is possible under Internal Revenue Code (I.R.C.) Section 72(e), which states that interest earned in an insurance contract (an annuity is an insurance contract) is not taxable to the owner until it is withdrawn. As long as the funds remain with the insurance company, the interest can accumulate completely tax deferred.

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