Reduce Tax on Annuity Payments

For many investors in fixed annuities, it can be difficult to increase income while minimizing taxation. Even though fixed annuities do provide safety and greater rates than most other types of fixed-income investments, annuity payments can be all ordinary income and therefore subject to the highest annuity tax rates. For instance, if an annuity holder is in the 28% tax bracket, then a $100,000 fixed annuity paying 5% can result in $5,000 a year in taxable interest income and 28% of $5,000 comes to $1,400 of tax. When you make simple withdrawals from an annuity, each withdrawal is taxed as interest earnings until you have withdrawn all of your interest. Further annuity payments to you are untaxed as they are return of your principal.

Would it be better if you could have these withdrawals taxed more beneficially? You can.

One possible alternative to this problem could be to annuitize a portion of the annuity policy and let the rest continue to grow tax-deferred, therefore taking advantage of favorable rules for annuity payments. This concept is similar to the 'split annuity' technique, except that it can be achieved in a single contract (assuming that your annuity company will permits partial annuitization).

For example, the owner of a $100,000 contract paying 5% interest could annuitize $30,000 of the balance and let the other $70,000 grow tax-deferred. The annuity payment exclusion ratio would then apply to the $30,000 annuitized portion, hence allowing for each payment to include a partial return of principal and be untaxed. The contract owner could receive the identical level of income as before, however with a much lower tax bill. In the mean time, the remaining $70,000 will increase in value to approximately $90,000 in five-years, thus replenishing the contract principal from within.

Of course, several elements will enter in to whether annuitization is a viable strategy for an individual, such as your level of income, tax bracket and whether or not you itemize deductions. Another good point is whether your current fixed annuity contract allows partial annuitization for annuity payments, as some insurance companies do not. If this is the case, then you'll need to move the account from your current annuity to a contract together with another carrier that offers this approach via a 1035 tax-free exchange.