Taxation of Income Annuities

[dgoldenz]

Can someone explain who came up with the taxation process of income annuities? It has been explained to me that the person receiving income would pay ordinary income tax on the full amount based on the income account value until they have withdrawn enough to get back to the original principal, at which point they will pay no tax on withdrawals until the value reaches $0, at which point they will go back to paying taxes on the full amount for the rest of their life.

Now, if that information is correct, what I don't understand is this.....isn't the income account value sort of an arbitrary number that has no real meaning? What is the difference between an annuity growing from $300k to $1 million, and then the company paying out 5% on a value of $1 million and paying out 1% of the account value on $5 million? The payment to the recipient is the same, but in the first scenario, they would pay taxes on the first $700k paid out, whereas the second they would pay taxes on the first $4.7 million, even though they received the same amount in each case. If all of this is correct, why wouldn't an insurance company offer no growth in value, but a much higher payout percentage (like 15% vs. 5%) of the value? You would end up with the same payouts, but the recipient would owe less taxes.....am I off base here, or am I just confused and the taxation would be on the growth on the accumulation side over the original principal as it is being taken out?

 

[padthaiforlunch]

Anything beyond basis is taxable.

Part of the appeal of an income account is that the client is NOT annuitizing, so if they pass before the account value is zero, the remainder is to the beneficiary.

So, a no-growth income account means my heirs will probably get nothing. People want account growth and preservation.

 

[insuranceexec]

Anything beyond basis is taxable.

Part of the appeal of an income account is that the client is NOT annuitizing, so if they pass before the account value is zero, the remainder is to the beneficiary.

So, a no-growth income account means my heirs will probably get nothing. People want account growth and preservation.

Absolutely correct. LIFO= Last in / First out.

 

[dgoldenz]

Anything beyond basis is taxable.

Part of the appeal of an income account is that the client is NOT annuitizing, so if they pass before the account value is zero, the remainder is to the beneficiary.

So, a no-growth income account means my heirs will probably get nothing. People want account growth and preservation.

But if the accumulation value is separate from the income account value, what's the difference? The income value paid out each year is paid as a percentage of the income account value.....whether the income account value is $500k or $5 million, if the person is withdrawing $50k per year from that amount based on the allowed withdrawal percentage, only $50k per year is withdrawn from the accumulation side regardless of the income account value. Once the owner dies, the income account value is meaningless since the beneficiary only gets what is left on the accumulation side.

 

[insuranceexec]

Once the owner dies, the income account value is meaningless since the beneficiary only gets what is left on the accumulation side.

Most income annuities do operate this way.

There are a couple newer "income" annuities that will allow the bene to receive the remainder income account value over a period as short as 5 years.

 

[dgoldenz]

Most income annuities do operate this way.

There are a couple newer "income" annuities that will allow the bene to receive the remainder income account value over a period as short as 5 years.

That may be, but assuming that's not the case, what's the difference?

 

[padthaiforlunch]

While the income account is used to calc the payments, the accumulated value is decreased by the payments made.

The income account will pay out for life, even if the accumulation value reaches zero. In this scenario, the mirrors lifetime annuitization of the accumulation value.

If, however, the client dies before the accumulation side reaches zero, then the remainder goes to the beneficiaries.

Now the carrier could have an income account with no growth value and pay a higher percentage, but that would be bad marketing.

If the carrier offers too high a growth rate and a very low withdrawal rate it might come across as gimicky and, again, bad marketing.

But if the accumulation value is separate from the income account value, what's the difference? The income value paid out each year is paid as a percentage of the income account value.....whether the income account value is $500k or $5 million, if the person is withdrawing $50k per year from that amount based on the allowed withdrawal percentage, only $50k per year is withdrawn from the accumulation side regardless of the income account value. Once the owner dies, the income account value is meaningless since the beneficiary only gets what is left on the accumulation side.

 

[arnguy]

As insuranceexec stated it is taxed on LIFO. Prior to 1986 (not certain of the year) it was the other way around. i.e., FIFO= fist in/first out. In other words, you would draw down all of the principal first before the interest that was left became taxable.

 

[padthaiforlunch]

Right, I missed the point.

If we make income account value equal the accumulation account (presumably lower) still have to pay taxes on gains, but since tehy are lower, we will hit basis sooner.

Do your clients want to make less money so they pay less taxes?

An alternative to the income annuity, with a lower tax bill is to use a split annuity. The growth part will continue to defer taxation and the immediate annuity is only taxed on the portion that is above basis.