Some insurance companies offer variable annuities, which are tax-deferred investments that distribute money to the annuity holder in a variety of ways, including as a series of regular payments for the rest of her life. Unlike fixed annuities, variable annuities allow their owners to choose how the money is invested. The amount of taxes due on withdrawals from a variable annuity depends on how the owner takes the money and when she opened the annuity.
The growth in an annuity compounds untaxed while it is left in the annuity. This feature is especially important for variable annuities, as the owner does not have to pay tax on the sale of any investments inside the annuity when changing the allocation. When it's time to pay taxes on the earnings, the money is taxed as ordinary income.
Lump-sum withdrawals from annuities opened after Aug. 13, 1982, are taken by the last-in, first-out, or LIFO, method. Annuity owners withdraw the growth first, paying tax on the full amount of their withdrawal or just on the growth funds, whichever is lesser. Once the owner has withdrawn all the earnings from the annuity, any further amount withdrawn is considered a return of the owner’s original investment and is not taxed.
The Tax Equality and Fiscal Responsibility Act of 1982 (TEFRA) changed the accounting method for withdrawals from annuities opened after Aug. 13, 1982. Annuity withdrawals subject to TEFRA occur on the LIFO method, while annuities opened before that date are withdrawn on a first-in, first-out, or FIFO, method. This method allows annuity owners to take all of their original investment out of the annuity tax free before any withdrawals come from growth.
Variable annuity owners can settle their annuities into regular payments for either a fixed period or for life. Annuity settlement payments are considered both a return of capital and payment of taxable growth. The amount of tax due on each payment is determined by the exclusion ratio, which is the ratio of original investment to expected payout. If the recipient of annuity settlement payments lives long enough that he has received all of his original investment, any subsequent payments become entirely taxable.
The company issuing the owner’s annuity is responsible for sending a Form 1099 to both the Internal Revenue Service and the annuity owner reporting any taxable withdrawals. Additionally, the company is responsible for making adjustments to the annuity owner’s basis in the policy. The taxable withdrawal from an annuity is included on the recipient’s Form 1040 (Individual Tax Return).
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