Taxation Of Individual Annuities Accounting Essay


Avoiding taxes is, when done legally, one of those things that almost everyone truly enjoys. the most attractive feature of Annuity is "Tax-Deferred Growth". Deferred Annuity is a type of contract that delays payment of income installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase (in which you invest money into the account) and the income phase (in which the plan is converted into an annuity and guaranteed payments are received). It can be either variable or fixed. Earnings on a deferred annuity account are taxed only upon withdrawal, providing the annuity with a tax benefit. This type of annuity also provides a death benefit, so that the beneficiary of the annuity is guaranteed the principal and the investment earnings. For example; an investor may choose to defer annuity payments until she retires.

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For some investors, an annuity can be an appropriate part of their financial plan if utilized properly. Unfortunately, annuities are very complex insurance instruments that are sometimes sold inappropriately - their buyers often don't receive full and clear explanations of how the annuities work. And indeed, as long as the money remains inside the annuity, the government won't tax any of the earnings. But all good things must come to an end, and sooner or later a tax-deferred annuity is going to get taxed. Let's take a look, then, at how and when that happens.

A deferred annuity has two phases :

The Accumulation Phase and

The Distribution Phase/ Annuitization Phase/ Payout Phase

The Accumulation Phase

The phase in an investor's life when the annuitant is making contributions to the annuity and builds up the value of his/ her annuity account or the investment portfolio with the intention of having a nest egg for retirement. the annuity grows untaxed through the years as the investment compounds. In other words, by choosing to defer spending until later in life, individuals create savings that can be invested in the marketplace and therefore grow over time. If they periodically invest money over the duration of their working lives, individuals can create a very lengthy accumulation period during which their savings can grow to substantial proportions. Here the contributions by the annuitant are directly proportional to his/ her income stream i.e. the greater the contributions are during the accumulation period (and the longer the accumulation period is), greater will be the income stream as soon as the annuitant begins the annuitization phase.

Distribution Phase/ Annuitization Phase/ Payout Phase

In insurance-speak, a series of scheduled payments is called "annuitization," and the recipient is called the "annuitant." This phase begins when the annuitant starts receiving payments from the annuity. These payments are called annuity distributions. Distributions typically consist of principal and earnings. If the annuitant follows the annuity rules, the annuity will accumulate earnings on a tax-deferred basis until the annuitant make withdrawals. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime.

Electing Not to Take Payments

some individuals have no need for income from the funds that have accumulated in their annuity. if the same is true for you, be sure to check your beneficiary designation is correct since the annuity can be transferred to your beneficiary at your death.

How does the Insurance Company Compute Your Monthly Payment ?

There are several factors that insurance companies use to compute your monthly payment amount; two of the most common are 'gender' and 'age' both of which affect your life expectancy. Since women have longer life expectancies than men. Women won't receive as high of a payment as their male counterparts. Hence, the older you are, the lower your life expectancy. For example; a 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man because the older man's life expectancy is shorter.

The payout option that the annuitant selects - which affects how long the payments will last. for example; if the annuitant selects the joint-life option, the monthly payout most likely will be lower as the payment continues to the spouse after the annuitant's death.

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The insurance company that the annuitant selects, and its expected investment returns on his/her money. If the company can make a 5% instead of a 3% return with his/ her money, the payment will be higher. However, the increase in his/ her payment when returns are higher depends on whether he/ she select a fixed monthly payout or a variable monthly payout from his/her annuity. If he/she selects the fixed amount, the payout will not change, and the insurance company assumes all investment risk. Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so the market risk is assumed.

Annuity Payout Options

There are a few different methods for taking annuity payouts. Generally speaking, the most common methods to receive cash payouts are :

Annuitization Method

Systematic Withdrawal Schedule

Lump-Sum Payment

Annuitization Methods

This method gives some guarantee of monthly income for a determined period. Different options with this method are :

Life Option: The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant. This option provides an income stream for life, which is an effective hedge against outliving your retirement income.

Joint-Life Option: This common option allows you to continue the retirement income to your spouse upon your death. The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife.

Period Certain: With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years. Should you elect at 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years.

Life with Guaranteed Term: Many people like the idea of income for life (which they get with the life option), but they are afraid to choose that option in case they die in the near future. The life-with-guaranteed-term option gives you an income stream for life (like the life option), so it pays you for as long as you live. But with this option, you can select a guaranteed period, such as a 10-year guaranteed term for which your annuity is obligated to pay to your estate or beneficiaries even if you die before that guaranteed period is over.

Systematic Withdrawal Schedule

Under the Systematic Withdrawal Schedule, the annuitant has complete control over the timing of distributions but no protection against outliving annuity assets. Under this method, he/ she can select the amount of payment that he/ she wishes to receive each month and how many he/ she wants to receive. However, the insurance company will not guarantee that he/ she will not outlive his/ her income payments. How much he/ she receives and how many months he/ she receive payments depends on how much he/ she has in the account. The burden of life-expectancy risk is on his/her shoulders.

Lump-Sum Payment

Taking out the assets in the annuity in one lump sum is usually not recommended because, in the year the annuitant takes the lump sum, ordinary income taxes will be due on the entire investment-gain portion of his/ her annuity. Clearly, this is a very inefficient payout option from a tax minimization perspective.

Tax Treatment of Annuity Payouts

Regardless of the payment method, some income taxes will be due on every annuity payment the annuitant receives. if the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into the annuity and its value when it is paid back.

Taxes on a Lump-sum Distribution

Say for example, you invested Rs.100,000 over the years into a Trans First Life annuity that is worth Rs.250,000 when you retire at age 62. If you take that amount in a lump sum, you will owe taxes on your gain of Rs.150,000. Fair enough -- the Rs.150,000 is an investment gain, and just about all successful investments require that taxes be paid someday. But, Uncle Sammy says that an annuity gain is ordinary income, so the taxes you will pay on that amount will be computed based on the ordinary income tax rates in effect in the year of distribution. You get no capital gains tax break on your earnings.

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Taxes on Annuitizing

If the annuitant annuitizes -

Part of each payment is considered as a "Return of Previously Taxed Principal" (i.e., his/ her investment) and

Part as "Earnings"

(Think of it as the reverse of paying a mortgage, where part is principal and part is an interest payment.) You will owe income taxes on the part of the payment that's considered earnings.

The amount of each payment that won't be taxed is computed by establishing an "exclusion ratio" that is determined by dividing the investment in the contract by the total amount he/ she expects to receive during the payout period. Once payout method is selected with the insurance company, he/ she should ask for the 'Exclusion Ratio', which tells that how much is excluded from being taxed. Exclusion Ratio is the portion of the return on investments that is income tax exempt. It represents a payback of initial investments rather than capital gains. It arises mainly through different forms of non-qualified insurance annuities).  For example, if the exclusion ratio is 80% on a Rs.1,000 monthly payout, then Rs.800 is excluded from income tax and Rs.200 is subject to ordinary income tax.


Assume you have a fixed annuity in which you've invested Rs.100,000 that will pay you a sum of Rs.750 per month for life starting at age 62.

According to IRS life expectancy tables, you will receive those payments for 22.5 years, so your contract's value is Rs.202,500 (12 Ã- Rs.750 Ã- 22.5). Your exclusion ratio is 49.4% (Rs.100,000/Rs.202,500). Therefore, out of the Rs.9,000 the annuity pays each year, you may exclude Rs.4,446 from income. The remaining Rs.4,554 of that payment will be subject to ordinary income taxes.

Taxes on Variable Annuities

Taxes on a variable annuity work a little differently. In a variable annuity, the annuitant does not actually know how much the annuity payment will be each month because the market value of his/ her investment will change based upon market situation. Accordingly, the excludable amount of each annuity payment is determined by dividing his/ her investment by the period over which he/ she expects to receive the annuity.

In the preceding example, the annuity would make a payment for 270 months (12 Ã- 22.5). Therefore, if the investment was in a variable annuity, the amount to be excluded from every monthly payment would be Rs.370 (Rs.100,000/270). The remainder of each payment would be declared and taxed as income for that year.

Points to Ponder

Deciding on the best annuitization payout method to choose for your annuity is not an easy decision. Consider your priorities, the amount you need each month and how long you think you will need these payments.

A final factor to consider is the credit quality of the insurance company. Remember that just because you have accumulated your annuity at one insurance company over the past 20 years, you don't necessarily need to start your payouts with them.

If another insurer with a high rating has offered you a higher monthly payout, it might be worth your time to look into doing a tax-free 1035 exchange to the new insurer, but make sure to check the surrender charges on your current contract before you initiate any transfer!

The insurance companies have well-paid employees in specialized departments that will provide you with an estimated payout for each option. Make them earn that extra 1.5% in fees that they charge annually to your contract - have multiple quality insurance companies give you a quote on the current value of your annuity with multiple payout options.

Frequently Asked Questions

The confusing Case of Withdrawals

A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. Those payments are taxed based on when the annuity was purchased.

For annuities purchased before Aug 14, 1982, the FIFO (first-in, first-out) method is used for withdrawals.

For annuities purchased after Aug. 13, 1982, the withdrawal rule is LIFO (last-in, first-out), meaning that earnings will come out first, i.e., for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract.

Premature Distributions (those occurring before you reach age 59.5) are subject to a 10% penalty.

You have to pay not only a 10% penalty on the withdrawal, but also income tax on any portion of the withdrawal attributable as investment gain. It is not a wise decision to pull funds prior to age 59.5, so try to avoid it at all costs.

If the annuitant dies prior to receiving any payments

Then the money will go to the contract's beneficiaries. On receipt, the beneficiaries will be taxed on the earnings in the annuity at ordinary income tax rates.

If the contract had been annuitized prior to the annuitant's death

Then there may or may not be an income tax impact. If the annuitant opted for a life only annuity, then at death nothing passes to heirs and no income taxes are due.

If the annuitant selected a term-certain option and died before that period elapsed

Then remaining payments will be paid to someone, and the recipient will pay ordinary income tax on all earnings previously unpaid to the deceased.

A Joint-Life Annuitant (e.g., a surviving spouse)

Will continue to receive income tax exclusion on part of the annuity payments until the entire investment in the contract is recovered.

individual retirement accounts (IRAs)

An individual retirement account (IRA) allows workers with taxable compensation to make annual contributions to a retirement plan (permits individuals to set-aside money each year) up to certain limits and receive favorable income-tax treatment. The main advantage of an IRA is that you defer paying taxes on the earnings and growth of your savings until you actually withdraw the money. The main demerit is the tax law imposes stiff penalties if you withdraw the funds before you turn age 59.5 years old. The Economic Growth and Tax Relief Reconciliation Act of 2001 have substantially increased the tax advantages of IRAs. Maximum annual contribution limits are increased, and special catch-up rules allow older workers to make additional contributions. There are two basic types of IRA plans :

Types of IRA

There are a number of different types of IRAs, which may be either employer-provided or self-provided plans. The types include:

Traditional IRA

Roth IRA


Simple IRA

Self-Directed IRA

Traditional IRA - Allows to save money without paying taxes until it is withdrawn. The money you put into the IRA can lower your taxable income and grows tax-free while it's in the IRA account. Contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings with the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). Depending upon the nature of the contribution, a traditional IRA may be referred to as a "deductible IRA" or a "non-deductible IRA."

Roth IRA - Offer a slight twist on the traditional IRA. There are differences in the tax advantages and who can open a Roth IRA. The most attractive part of Roth IRAs is that the money can be withdrawn without paying federal taxes. Contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William Roth.

SEP IRA - a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name, instead of to a pension fund account in the company's name.

Simple IRA - a simplified employee pension plan that allows both employer and employee contributions, similar to a 401 (k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.

Self-Directed IRA - A self-directed IRA that permits the account holder to make investments on behalf of the retirement plan.

Points to Ponder

Traditional and Roth IRAs are established by individual tax payers, who are allowed to contribute 100% of compensation (self-employment income for sale proprietors and partners) up to a set maximum dollar amount.

Contributions to the Traditional IRA may be tax deductible depending on the tax payer's income, tax filing status and coverage by an employer-sponsored retirement plan.

Roth IRA contributions are not tax-deductible (i.e., Tax-free)

SEPs and SIMPLEs are retirement plans established by employers. Individual participant contributions are made to SEP IRAs and SIMPLE IRAs.

With the exception of Roth IRAs, where eligible distributions are tax-free, eventual withdrawal from an IRA is taxed as income; including the capital gains. Because income is likely to be lower after retirement, the tax rate may be lower.

Combined with potential tax savings at the time of contribution, IRAs can prove to be very valuable tax management tools for individuals.

Also, depending on income, an individual may be able to fit into a lower tax bracket with tax-deductible contributions during his or her working years while still enjoying a low tax bracket during retirement.

Exhibit 3 : Differences Between Traditional IRA and Roth IRA


Traditional IRA

Roth IRA


All workers under age 70 1/2 at the end of the calendar year. (same rule applies to Spousal IRA).

• No age restrictions to open.

• Fully Eligible;

if income < $105,000 (single)

or $167,000 (joint)

• Not Eligible;

if income > $120,000 (single) or $ 177,000 (joint)


Made with pre-tax income

Reduces gross taxable income for that year by the amount contributed.

Made with after-tax income.

Maximum Contribution

(per individual)

Tax Year 2009

Under age 50 : $5,000

Over age 50 : $6,000

Tax Year 2010

Under age 50 : $6,000

Over age 50 : $6,000


Tax Benefits of Contributions

• Fully Deductible, if you don't have an employer retirement plan.

• Non-Deductible, if you're covered by an employer retirement plan and have a modified adjusted gross income above $66,000 (single) $109,000 or $160,000 (married filing joint, and depending on who has a retirement plan at work).

Partially deductible, if you

have a modified adjusted

gross income in 2010 between $56,000-$66,000 (single) or between $89,000-$109,000 (married filing joint).

Not Deductible. If converting from IRA to Roth IRA, the taxable portion of the IRA is taxed in year of conversion.


No Annual Limit on amount rolled over from another qualified plan



May convert from IRA to Roth IRA if income is $100,000 or less. You can convert existing traditional IRAs over to Roth IRAs in 2010 regardless of your income.

Earnings/ Withdrawals

Untaxed until withdrawn.

• All qualified distributions after age 59 1/2 are untaxed.

• Could be penalty if not in account for at least 5 years.


Must begin distributions by April 1 in year after turning 70 1/2.

If distribution less than minimum annual requirement, penalty of 50% of amount that should have been distributed.

No distribution requirements, except possibly in case of death.

distributions before Age 59 1/2

Generally taxable and subject to 10% early withdrawal penalty, unless exceptions :

$ 10,000 not penalized (but taxable) if withdrawn for first-time home purchase. Full amount taxable but not penalized for certain other situations.

Earnings generally taxable and subject to 10% early withdrawal penalty, unless exceptions:

$ 10,000 not penalized (but taxable if in account for less than 5 years) if withdrawn for first-time home purchase. Any earnings taxable but not penalized for certain other situations.

SELECTED REFERENCES Getting Ready to Retire : What You Need to Know About Annuities, 2002.

Insurance News Network -

Quicken Insure Market -

Association of Private Pension and Welfare Plans -

Black, Kenneth;and Harold Skipper. Life Insurance. 12th ed. Englewood Cliffs, NJ:Prentice-Hall, 1994. (Provides additional detail on the topics covered in this chapter)


It has been stated that an annuity is "upside-down" life insurance. Explain what is meant by this notion.

Explain why death rates for life insurance buyers generally are higher than for people who buy annuities.

Describe the tax treatment of annuities :-

During the accumulation period

When distributed

What is the sequence of net premiums for one-year term policies with face amounts equal to Rs. 1000 for a male for the ages 60 through 62, assuming an interest rate of 6 percent ? Assume premiums are paid at the beginning of the year and claims are paid at the end of the year ?

(Hint : With deferred annuities, a person pays an annuity premium to an insurer, who in turn invests this premium (net of expenses) until the payout period begins. The returns earned on the annuity are not taxed as they are earned. Consequently, annuities provide a tax-advantaged method of savings.)

Describe the various provisions that may be included in a pension plan with respect to death or disability of a plan participant ?

Who is eligible to establish individual retirement accounts ? What is the maximum deductible contribution that may be made on behalf of participants under IRAs ?

Explain the basic characteristics of a traditional IRA and a Roth IRA ?

Explain the income tax treatment of a traditional IRA and a Roth IRA ?

What are the annual contribution limits to an IRA ?

What is an IRA rollover ?