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Annuity Taxation

As you’re probably well aware, the income and returns that you can expect from your investment portfolio has as much to do with the tax code as it does your return on investment. Above all else, annuities provide an investment vehicle that are largely protected against an aggressive tax code.

Annuities (specifically deferred annuities) are generally sold by insurance companies, primarily those that issue life insurance policies. Annuities are a natural extension of the life insurance business because the firm has to offer an annuity payout schedule that is based on your life expectancy. Thus, when you purchase an annuity, you’re betting that you’ll live a very long time. Likewise, when you buy a life insurance policy, you’re betting that you won’t live very long, or at least, you’re willing to insure the chance that you won’t live very long.

The tax efficiency of annuities comes from friendly tax codes that allow your investments to grow, tax deferred until you begin to make withdrawals. So, if you were to buy a $50,000 annuity at age 60, and it grows to $85,000 by age 70, you wouldn’t incur a single tax burden until you began to withdraw your principle investment. Your capital gains of $35,000 and your principle investment of $50,000 will be returned at the same time as you begin to receive regular monthly retirement payments.

Let’s assume that you’ve $50,000 saved up and you would like to purchase an annuity. You head to your nearest insurance broker, who likely also sells annuities, and buy a $50,000 annuity. The life insurance company, hedging its bet on your life expectancy, tells you that it will agree to pay you $350 a month until the day you die in return for your $50,000 investment.

As you can already see, annuities offer a higher drawdown percentage than other fixed income investments since the return ends at death. A $50,000 annuity paying out $350 per month has an effective annual payout of roughly 8.4% per year, however you should be sure to note that figure includes some principle. In fact, for the first 12 years, you’ll have your principle investment returned.

When you moderate the annual payout based on your life expectancy, you can see how much you would earn per year. For example, if you made the assumption that you had about 20 years until death, that $50,000 annuity would actually yield about 5.7% annually. Not too shabby.

So, how do you calculate your taxes due? The IRS has made it very simple using a depreciation table. The IRS assumes that at age 70, you’re likely to only live another 16 years. So, in that 16 year period, your annuity will return $67,200 using the same example above, and your taxes would be limited to only that $17,200 over your principle investment.

Your return on investment is just over 25%, so with each annuity payment only 25% of it is taxed at your normal income rate. In the above example, a $350 a month payment would be $87.50 in earnings, and $262.50 in principle. Compare that to a money market account yielding the same 5.7% in which ALL of your earnings would be taxed. As you can see, as a percentage of assets, annuities are taxed at far lower rates than other fixed income investments.