An annuity is both a contract with an insurance company and
an investment. Your contributions (often called premium
payments) to it are invested to produce earnings. This
article explains when and what is taxed as income under
annuitization, withdrawals, and gifts of your annuity.

An annuity has two phases: accumulation and annuitization.
During accumulation - called a deferred annuity - both your
contributions (i.e. premium payments) and their earnings
accumulate within the contract. During annuitization (i.e.
payout stage) you receive monthly payments while money
remaining in the contract creates more earnings.

Most annuities are nonqualified. You can make unlimited
after-tax contributions to them and their earnings grow
tax-deferred. Only the tax-deferred earnings are eventually
subject to income tax; your contributions come out tax-free
as a return of your basis in the contract.

A qualified annuity is one regulated under government rules
as a retirement plan. All contributions to them are
deductible from income but, of course, must come from
working income.

Annual contributions are limited like IRA contributions.
Since they have no after-tax contributions, your tax basis
in the contract is zero; so all withdrawals will be
subjected to income tax.

Like all qualified plans, any withdrawal you make before
reaching age 591/2, will have a 10% penalty tax imposed on
it in addition to income tax. After reaching 701/2, you're
required to make minimum required distributions - just like
IRAs.

Income taxation is imposed on:

* Annuitization

* Accumulation withdrawals

* Gifts of an annuity, and

* Beneficiary's withdrawals

Let's see how nonqualified annuities are taxed:

Taxation on annuitization payments:

Your monthly payouts are considered as made up of a
contribution part and an earnings part. Only the earnings
part is taxed as income. It's a specific fraction of your
payment equal to total earnings divided by the contracts
total value - i.e. earnings plus contributions. After
you've received all your contributions back in payouts, all
future payouts are fully taxed as income.

Taxation on withdrawal from your deferred annuity
accumulation:

Taking money out of your deferred annuity is a withdrawal.
But earnings are considered to come out first. So anything
you withdraw is taxed as income until all the earnings are
out. Any withdrawal beyond earnings is a tax free return of
basis.

Until you've turned 59 years old, the IRS imposes a 10%
penalty tax on what you take out of your nonqualified
annuity too.

This withdrawals taxation also includes cashing out your
deferred annuity altogether. An early cash out may trigger
an additional fee from the annuity company.

Taxation on a gift of your deferred annuity:

Gifting your deferred annuity to a person, charity or a
charitable remainder trust, triggers income tax on the
annuity's earnings; that includes any 10% penalty tax too.

For gifting to a government-approved charity, your
deduction is limited to your basis in the contract - i.e.
the sum of your contributions.

Qualified annuities are taxed as above accept they have no
basis - i.e. basis equals zero.

Taxation on beneficiaries and survivors:

Annuities that go to beneficiaries and survivors are
considered as 'income in respect of a decedent' - and not
as an investment. So an annuity - unlike an investment -
doesn't get a stepped-up basis.

So, any annuity payout to survivors and beneficiaries is
subject to income tax - but only to the extent that money
paid out to them exceeds the annuity's basis -i.e. the
original owner's annuity contributions. So a portion of
each payout will be attributed to the deferred tax on the
earnings of those contributions and a portion will be
return of basis.

As it was for the original owner, when the basis has been
completely recovered through payments to the beneficiary,
all further payments will be fully taxed as income.

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Shane Flait writes and consults on financial, legal, tax,
and retirement issues. He gives you workable strategies to
accomplish your goals.
Get his FREE report on Managing Your Retirement =>
http://www.easyretirementknowhow.com/FreeReportandSignUp.htm
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You can contact him at contact@easyretirementknowhow.com

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