How is Taxation Applied?
You should consult your tax professional for complete information regarding annuity taxation. Following is a basic summary of certain tax considerations of which you should be aware.
A qualified annuity is taxed identically to any other qualified account such as an IRA, 401(k), profit sharing plan or other tax-deferred retirement account.
Non-qualified annuities are taxed differently from most investments:
Withdrawals – Withdrawals of earnings from a nonqualified annuity are fully taxable at ordinary income tax rates. Unless the annuity was purchased before August 14, 1982, the earnings are considered withdrawn first and are therefore subject to taxation. All withdrawals will be fully taxable as ordinary income until the account value reaches the initial amount invested. Because annuity income is taxable at ordinary income tax rates, you do not receive the benefit of lower capital gains tax rates. Also, if you are under age 59 1/2 when you make the withdrawal, you may be assessed a 10% penalty on any taxable earnings.
Annuitized Payments – If you annuitize a nonqualified annuity, a portion of your payment will be considered a return of premium and will not be subject to ordinary income tax. The amount that is taxable will be determined at the time you elect to annuitize the policy. A calculation will be made by the insurance company to determine the “exclusion ratio,” which will determine the percentage of each payment that will be excluded from income tax.
Taxation at Death – Spousal Continuation – Many variable annuities enable your spouse to continue the policy at your death. Some companies will pay the death benefit into the policy and continue the original policy without tax consequences. Others will require your spouse to choose either the death benefit (if the account value is lower than the death benefit) or spousal continuation. Choosing the death benefit in these situations would be a taxable event; your spouse would be taxed at ordinary income tax rates on the difference between the death benefit and the amount you invested, adjusted for any withdrawals. In most cases, the policy would not be included in your taxable estate for estate tax purposes due to the marital allowance. You should consult the prospectus for the terms of spousal continuation.
Taxation at Death – Non-Spousal Beneficiary – At your death, the death benefit will be paid to the non-spousal beneficiaries you have designated. By doing so, the transfer will avoid probate. Unlike most other securities, there is no step-up in cost basis at your death. Instead, any deferred income in the policy will be taxable to the beneficiaries as ordinary income at their tax rates. If a death benefit is paid out that is higher than the account value, the difference between the death benefit and the amount you invested, adjusted for any withdrawals, will be taxable as ordinary income to the beneficiaries. The value of the variable annuity policy also will be included in your estate for estate tax purposes. Beneficiaries have the choice of taking a lump sum payment or receiving the payments over a period of time, thereby spreading out the income tax liability.
How to convert Taxable Income to Tax Free Income utilizing a ROTH CONVERSION while receiving income during income distribution.
In the year prior to your Annuity account value reaching zero, you can do a “Roth Conversion” on the remaining annuity account value. From that point forward, all annuity income will payout TAX-FREE.
Here’s the IRS link that explains the Roth conversion. It’s all the way at the bottom of the page.
IRS LITTLE KNOWN SECRET
TAX STRATEGY DISCLOSURE
Birdseye Financial, Corbin Lindsey and any other advisors associated with Birdseye Financial, do not offer any tax or legal advice. We provide strategies for educational purposes only. You should consult your tax and / or legal professional for complete information regarding any tax and legal matters.
The information listed on this website and on any document from Birdseye Financial that is provided by Birdseye or by a third party has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Birdseye Financial. While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use or reliance upon this information..
Life Insurance Taxation
You should consult your tax professional for complete information regarding life insurance taxation. Following is a basic summary of certain tax considerations of which you should be aware.
Understanding the importance of life insurance is one thing. Understanding the tax rules is quite another. As insurance products have evolved and become more sophisticated, the line separating insurance vehicles from investment vehicles has grown blurry. To differentiate between the two, a mix of complex rules and exceptions now governs the taxation of insurance products. If you have neither the time nor the inclination to decipher the IRS regulations, here are some life insurance tax tips and background information to help you make sense of it all.
Life insurance contracts must meet IRS requirementsFor federal income tax purposes, an insurance contract cannot be considered a life insurance contract--and qualify for favorable tax treatment--unless it meets state law requirements and satisfies the IRS's statutory definitions of what is or is not a life insurance policy. The IRS considers the type of policy, date of issue, amount of the death benefit, and premiums paid. The IRS definitions are essentially tests to ensure that an insurance policy isn't really an investment vehicle. The insurance company must comply with these rules and enforce the provisions.
Keep in mind that you can't deduct your premiums on your federal income tax returnBecause life insurance is considered a personal expense, you can't deduct the premiums you pay for life insurance coverage.
Employer-paid life insurance may have a tax costThe premium cost for the first $50,000 of life insurance coverage provided under an employer-provided group term life insurance plan does not have to be reported as income and is not taxed to you. However, amounts in excess of $50,000 paid for by your employer will trigger a taxable income for the "economic value" of the coverage provided to you.
You should determine whether your premiums were paid with pre- or after-tax dollarsThe taxation of life insurance proceeds depends on several factors, including whether you paid your insurance premiums with pre- or after-tax dollars. If you buy a life insurance policy on your own or through your employer, your premiums are probably paid with after-tax dollars.
Different rules may apply if your company offers the option to purchase life insurance through a qualified retirement plan and you make pretax contributions. Although pretax contributions offer certain income tax advantages, one tradeoff is that you'll be required to pay a small tax on the economic value of the "pure life insurance" in the policy (i.e., the difference between the cash value and the death benefit) each year. Also, at death, the amount of the policy cash value that is paid as part of the death benefit is taxable income. These days, however, not many companies offer their employees the option to purchase life insurance through their qualified retirement plan.
Your life insurance beneficiary probably won't have to pay income tax on death benefit receivedWhoever receives the death benefit from your insurance policy usually does not have to pay federal or state income tax on those proceeds. So, if you die owning a life insurance policy with a $500,000 death benefit, your beneficiary under the policy will generally not have to pay income tax on the receipt of the $500,000. This is generally true regardless of whether you paid all of the premiums yourself, or whether your employer subsidized part or all of the premiums under a group term insurance plan.
Different income tax rules may apply if the death benefit is paid in installments instead of as a lump sum. The interest portion (if any) of each installment is generally treated as taxable to the beneficiary at ordinary income rates, while the principal portion is tax free.
In some cases, insurance proceeds may be included in your taxable estateIf you hold any incidents of ownership in an insurance policy at the time of your death, the proceeds from that insurance policy will be included in your taxable estate. Incidents of ownership include the right to change the beneficiary, the right to take out policy loans, and the right to surrender the policy for cash. Furthermore, if you gift away an insurance policy within three years of your death, then the proceeds from that policy will be pulled back into your taxable estate. To avoid having the policy included in your taxable estate, someone other than you (e.g., a beneficiary or a trust) should be the owner.
Note: If the owner, the insured, and the beneficiary are three different people, the payment of death benefit proceeds from a life insurance policy to the beneficiary may result in an unintended taxable gift from the owner to the beneficiary.
If your policy has a cash value component, that part will accumulate tax deferredUnlike term life insurance policies, some life insurance policies (e.g., permanent life) have a cash value component. As the cash value grows, you may ultimately have more money in cash value than you paid in premiums. Generally, you are allowed to defer income taxes on those gains as long as you don't sell, withdraw from, or surrender the policy. If you do sell, surrender, or withdraw from the policy, the difference between what you get back and what you paid in is taxed as ordinary income.
You usually aren't taxed on dividends paidSome policies, known as participating policies, pay dividends. An insurance dividend is the amount of your premium that is paid back to you if your insurance company achieves lower mortality and expense costs than it expected. Dividends are paid out of the insurer's surplus earnings for the year. Regardless of whether you take them in cash, keep them on deposit with the insurer, or buy additional life insurance within the policy, they are considered a return of premiums. As long as you don't get back more than you paid in, you are merely recouping your costs, and no tax is due. However, if you leave these dividends on deposit with your insurance company and they earn interest, the interest you receive should be included as taxable interest income.
Watch out for cash withdrawals in excess of basis—they're taxableIf you withdraw cash from a cash value life insurance policy, the amount of withdrawals up to your basis in the policy will be tax free. Generally, your basis is the amount of premiums you have paid into the policy less any dividends or withdrawals you have previously taken. Any withdrawals in excess of your basis (gain) will be taxed as ordinary income. However, if the policy is classified as a modified endowment contract (MEC) (a situation that occurs when you put in more premiums than the threshold allows), then the gain must be withdrawn first and taxed.
Keep in mind that if you withdraw part of your cash value, the death benefit available to your survivors will be reduced.
You probably won't have to pay taxes on loans taken against your policyIf you take out a loan against the cash value of your insurance policy, the amount of the loan is not taxable (except in the case of an MEC). This result is the case even if the loan is larger than the amount of the premiums you have paid in. Such a loan is not taxed as long as the policy is in force.
If you take out a loan against your policy, the death benefit and cash value of the policy will be reduced.
You can't deduct interest you've paid on policy loansThe interest you pay on any loans taken out against the cash value of your life insurance is not tax deductible. Certain loans on business-owned policies are an exception to this rule.
The surrender of your policy may result in taxable gainIf you surrender your cash value life insurance policy, any gain on the policy will be subject to federal (and possibly state) income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out (plus any loans outstanding) and your basis in the policy. Your basis is the total premiums that you paid in cash, minus any policy dividends and tax-free withdrawals that you made.
You may be able to exchange one policy for another without triggering tax liabilityThe tax code allows you to exchange one life insurance policy for another (or a life insurance policy for an annuity) without triggering current tax liability. This is known as a Section 1035 exchange. However, you must follow the IRS's rules when making the exchange.
When in doubt, consult a professionalThe tax rules surrounding life insurance are obviously complex and are subject to change. For more information, contact a qualified insurance professional, attorney, or accountant.