A fixed life annuity ensures you a guaranteed income during your retirement years. Of course, the amount of income depends on how much you contributed to it -- and how much it has grown as well as your age when it began. Income options include a monthly payout based only on your life alone or under a joint and survivor option – or simply a fixed term )e,g, 15 years) or even life payments with a guaranteed term of say 10 years (should you die prior to the guaranteed term). But how much annuity tax will you have to pay on these annuity payments?
We will deal with a non qualified annuity here. Its tax-benefit is the tax-deferred growth of your investment until you take money out, but it is funded by your after-tax contributions.
Note that a qualified annuity – as in an Individual Retirement Annuity – is funded by pre-tax contributions as are most qualified plans and traditional IRAs. All withdrawals are taxed as ordinary income.
Since the contributions you make to the non qualified annuity are already taxed, they will not be taxed later as you withdraw your funds. They constitute the 'basis' of your investment in the annuity contract. You should find out what this is (from your annuity company), since you will need it to figure your annuity tax during distributions.
When you have chosen your monthly payout option and arranged for starting it, your total monthly income amount is set by your distribution contract. A portion of each monthly payout is considered a return of your basis (your contribution). You pay annuity tax only on the other portion of that monthly payout, the part that IRS considers earnings.
Annuity tax under term certain distribution
When the number of years for payouts are fixed (i.e. certain), then you will know just how many monthly payouts there will be. You simply divide the total number of months into your 'basis'; that gives you how much of each monthly payout that will not be subject to annuity tax. The rest of the monthly payout is taxed at ordinary income rates.
Annuity Tax under a life distribution
In this case, you use your life expectancy – at the start of your distributions – as the number of years over which your basis (i.e. your contributions) will be returned to you – just as if it were a term certain situation. So you calculate the number of months that implies and divide that number into your basis to find the non-taxable amount of each monthly payment. The remainder of the payout will be subject to annuity tax at your ordinary income rate.
What if you outlive the life expectancy of your distribution?
If you outlive your life expectancy (not a bad thing!) used in determining your basis above, then your basis (contribution) has been fully recovered. Unfortunately, all future monthly payouts are 100% subject to annuity tax at your ordinary income tax rate.
For those of you who started your annuity payouts before 1987, you can continue to maintain the same fraction of payout as non-taxable as you did before you fully recovered your basis. That is an extra annuity tax break for you!