For many fixed annuity investors, it can be difficult to maximize income while reducing their annuity income tax. Whilst fixed annuities do provide safety and greater rates than most other types of safe investments, the annuity income tax is normal income tax and therefore subject to the highest rates. For instance, if an annuity holder is in the 28% tax range, then a $100,000 fixed annuity paying 4 percent can result in $4,000 a year in after tax interest income and 28% of $4,000 comes to $1,120 of annuity income tax (plus state income taxes). Therefore, the taxpayer will only receive $2,880 to spend.
One possible alternative to this predicament could be to annuitize a portion of the annuity policy and let the rest continue to grow tax-deferred, thus taking advantage of favorable rules to the annuity income tax that apply to annuitization (annuitization manes trading part or all of the principal in the annuity for a stream of payments which can last a term or years or for life, your choice). This concept is similar to the 'split annuity' technique, except that it can be achieved in a single contract (assuming that your annuity company offers the partial annuitization feature).
For example, the owner of a $200,000 contract paying 4% interest could annuitize $50,000 of the balance and let the leftover $150,000 grow tax-deferred. The annuity exclusion ratio (the part of the annuity income payments not taxed) would then apply to the $50,000 annuitized portion, as a result allowing for each annuity income payment to have a partial annuity income tax free return of principal. The contract owner will receive approximately similar level of income as before, however with a much lower tax bill. At the same time, the remaining $150,000 will increase, annuity income tax deferred, to approximately $205,000 in 8 years, thus replenishing the contract value from within.
Of course, several aspects will enter in to whether by using principal is a viable strategy for anyone, such as your level of income, tax bracket and whether or not you itemize deductions on your tax return. Another point to consider in an effort to cut your annuity income tax is whether your current fixed annuity contract permits partial annuitization, as some insurance companies do not. If this is the case, you'll need to move the some or all of the account value from your current annuity to a contract along with another carrier that offers this approach via a 1035 tax-free exchange.
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