Annuities are investment contracts offered by insurance companies. Operating like life insurance in reverse, annuities offer a stream of payments that are guaranteed for as long as the owner lives. Additionally, annuities grow tax-deferred, helping policy holders sock away even more. But occasionally you have something you need your money for even more, and need to get out of an annuity. When you sell, you can recover any after-tax money in the policy – called your cost basis – tax-free.
Cost Basis Basics
Your cost basis in an investment is the amount you paid, using after-tax dollars, to buy into the investment. Figuring that you’ve already been taxed once on that money, the IRS gives you a pass when you take it back out. The amount of taxable income you report from selling an annuity is figured by subtracting your cost basis from the sale proceeds. For an investment like an annuity, you might add more money in or pull money out while you own it. Those types of transactions can impact your cost basis.
Adjustments to Basis
Any money you ever paid into your annuity contributed to its cost basis. Total all those payments together. Keep in mind that any payments for riders or additional features are not considered part of your basis, but something you purchased on the side. If you never took a cent out, then you’re done. On the other hand, if you withdrew from an annuity, then you might have reduced its basis. Withdrawals are taken on a last-in, first-out basis, so withdrawals typically come from growth first before removing principal. Check against your records from the annuity company. If you withdrew $10,000, but they only reported $9,000 of taxable income, then you need to reduce your basis by the $1,000 you already took back.
What Type of Gain
Many salespeople and investors think of annuities like other investments. The IRS doesn’t. Tax laws consider gain from the sale of an annuity as ordinary income, rather than capital gain. In exchange for all the years of tax-deferred growth, the taxes due on growth in an annuity are at a higher rate than capital investments. So unlike a gain of $400 from stock in a company, which is taxable at the preferential 0- or 15-percent rate, a gain of $400 from the sale of an annuity is taxable at the same rate as your other income – up to the maximum rate of 39.6 percent.
Who Keeps Track
Fortunately, the burden of tracking basis in an annuity falls on the shoulders of the insurance company. It’s never a bad idea to play along at home so you know exactly how much gain you would have to report if you needed to sell your annuity -- but if you lose track, it’s not the end of the world. Call your annuity provider and ask them for your current cost basis in the policy if you're considering selling it off.
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.