Tax on Annuity & Change of Ownership
People buy annuities for a variety of reasons. Annuities can offer a way to secure portions of your portfolio without sacrificing returns. You can also convert an annuity into a steady stream of money, making your own pension. Often sold like an investment, annuities receive different tax treatment than a savings account or a stake in a mutual fund. Understanding how annuities are taxed can help you structure any change of ownership efficiently.
General Tax Issues
Regardless of whether the annuity was established as a qualified retirement plan, annuities provide tax-deferred growth. Rather than reporting your annual gains on your taxes, you’re only required to report any untaxed amount you withdraw. When you take money out of an annuity before turning it into a payment stream, you typically take the growth out first, because tax laws use a last-in, first-out accounting method. If you settle the annuity, you’ll recognize a portion of each payment as tax-free return of principal and the other portion as taxable growth. The exclusion ratio -- the result of dividing your after-tax money in the annuity divided by your anticipated payout -- determines how much of each payment you don’t report as income.
Ownership of Annuities
Annuity contracts list three people aside from the insurance company who are involved. The annuitant is the person whose life determines the duration of the annuity. The beneficiary receives any death benefit or unpaid amount due when the annuitant dies. The owner has control over the contract, which includes the right to make withdrawals, designate beneficiaries or settle the annuity. Typically the annuitant is also the owner but has the power to transfer ownership to someone else.
Gifts or Inheritance
You can give an annuity as a gift, which allows the recipient to defer any taxes until making a withdrawal. Should you die before settling the annuity into a payment stream, your beneficiary takes ownership. You or your estate might owe taxes on the transfer depending on the total value of the annuity. As of publication, you can give up to $14,000 per person without incurring a gift tax, and you can exclude up to $5,250,000 from estate taxes. If you give the annuity as a gift, you’ll recognize any untaxed gain on your tax return and the recipient will only be responsible for the taxes on subsequent gain. The person who inherits your annuity would keep your same basis plus any amount your estate paid in taxes on the annuity.
Sale of Annuity
You might also want to sell your annuity to someone else. People often sell their annuities back to the company, often referred to as surrendering the policy. But if you would incur hefty surrender charges or have started taking a regular income from the annuity, you might try to find a private buyer instead. You’ll report any gain over the amount of after-tax money you haven’t recovered. Though annuity income is taxed as ordinary income, any gain from selling ownership rights is taxed as capital gains income.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.