A tax-deferred annuity is an investment contract issued by an insurance company. As the name would imply, the investment grows tax-free until the assets are withdrawn. However, unlike most retirement accounts, in which the entire amount of a distribution is taxable, annuities are taxed depending on when and how the money within the contract is received.
Accumulation Phase
The accumulation phase of an annuity is the time when the investment contract is allowed to grow in value and before regular payments are made to an investor. Some annuities, known as immediate annuities, have a very short or nonexistent accumulation phase and begin making payments almost immediately. Other fixed annuities are longer-term investments that grow in value according to the agreed-upon rate in the annuity contract. Withdrawals during the accumulation phase are taxed on a last-in, first-out basis, meaning the earnings in the contract come out first and are subject to ordinary income tax. If all the earnings are withdrawn, the remaining withdrawals are tax-free returns of capital.
Annuitization Phase
During the annuitization phase, the contract stops growing in value at the accumulation phase rate and begins paying regular interest payments to an investor. Payments during the annuitization phase are usually of an equal amount over a time period specified in the annuity contract, such as over the life expectancy of the owner or for a predetermined number of years. Annuitization payments are partially a tax-free return of capital and partially a taxable distribution of interest.
Exclusion Ratio
The exclusion ratio determines how much of an annuity's payment is taxable during the annuitization phase. The exclusion ratio is the quotient of the expected amount you are going to receive from the annuity divided by the amount of your investment. The result of the calculation is the amount of your payment that is tax-free. Internal Revenue Service Publication 939 outlines how to perform this calculation based on the number of years you will receive a payment or your IRS-calculated life expectancy. For example, if your expected return from annuity payments is $400,000 and your total investment in the contract is $100,000, 25 percent of your return will be tax-free.
Lump Sum Distributions
For a lump-sum distribution, subtract your total investment in the contract from the amount of the distribution. The resulting sum is the taxable amount of your annuity payment.
Early Withdrawal Penalties
As with any tax-advantaged retirement investment, the IRS will assess a 10 percent penalty on any annuity withdrawals before you reach age 59 1/2. This penalty is in addition to any tax consequences.
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