This is the second article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the final article will discuss cases in which they do/don’t make sense as a part of a financial plan.
How a variable annuity is taxed depends on where it is held.
Variable Annuities within Retirement Accounts
If the variable annuity is held in a retirement account, the variable annuity is taxed (almost*) like anything else within that account. For instance, if one of the investment options in your 403(b) plan is a variable annuity, when you defer salary to contribute to the annuity within that plan, those deferrals will reduce your taxable income — and when you take money out of the plan it will be taxable as income.
Taxation of Nonqualified Variable Annuities
If the variable annuity is not held in a retirement account (i.e., it is a “nonqualified” annuity) it has unique tax characteristics.
First, earnings that occur within the account are not taxable while they remain in the account. That is, the account is tax-deferred much like a traditional IRA (but without the opportunity for a tax deduction when you make contributions).
This tax deferral is, generally speaking, a good thing, because it allows the account to grow more quickly. And the greater the expected return, the bigger this benefit is. (Because the greater the return, the greater the annual tax cost that you get to avoid via tax deferral.)
However, when earnings are distributed from the account they are taxable as ordinary income. If you’re using the variable annuity to invest in stocks, this is a big drawback relative to a taxable account, because it means that dividends and long-term capital gains that would have otherwise received beneficial tax treatment are instead taxed at a higher rate as ordinary income.
When your original investment is distributed from the account, it is not taxable. However, all distributions from the account are considered to come from earnings until there are no more earnings left in the account. (In other words, distributions are considered to come in the least favorable order.)
Also, earnings distributions that occur prior to age 59.5 are subject to a 10% penalty, unless you meet one of a few exceptions:
- You (the owner of the annuity) have died,
- You (the owner of the annuity) are disabled,
- The distributions are part of a “series of substantially equal periodic payments” over your life or life expectancy (or the joint lives/life expectancies of you and a joint annuitant), or
- The distribution is allocable to your investment in the contract that occurred before August 14, 1982.
Finally, there’s no step-up in cost basis when you die.
Taxation of Nonqualified Annuities, after Annuitization
After annuitizing a nonqualified annuity (i.e., after you convert it from a liquid asset into a guaranteed stream of income, as discussed last week), payments from the annuity are taxed in the same way as payments from any other nonqualified immediate annuity. That is, part of each payment is nontaxable because it is considered to be a return of your basis (i.e., the amount that you put into the annuity), while the remaining portion of each payment is taxable as ordinary income. Eventually, if you live long enough to receive all of your basis back (i.e., the sum of the nontaxable portions of the payments eventually totals your basis), further payments will be entirely taxable.
Tax Planning Considerations
In summary, relative to investing in a retirement account, investing in a nonqualified variable annuity provides only tax disadvantages. It’s essentially the same as nondeductible traditional IRA contributions (i.e., the least desirable type of retirement account contribution) but with two big disadvantages:
- Distributions are considered to happen in a less favorable order, and
- There’s no opportunity for Roth conversions.
Relative to investing in a taxable account, investing in a nonqualified variable annuity has one tax advantage (tax deferral) and a list of tax disadvantages (distributions of earnings are taxed at ordinary income tax rates when otherwise they might be taxed at lower rates, there’s no step-up in cost basis when you die, and there’s the possibility of a 10% penalty on early distributions).
So when would a nonqualified variable annuity offer a net tax benefit relative to simply investing in a taxable account? The ideal set of circumstances would be something along the lines of:
- You want to invest in an asset with high expected return and which does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
- You do not have room for that asset in your retirement accounts,
- You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
- You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).
Suffice to say, that situation is very uncommon. Most people have plenty of space in their retirement accounts to hold any high-return, tax-inefficient assets they want to own.
*I say “almost” here because a qualified variable annuity that has been annuitized has slightly different tax treatment than other things within a retirement account. Specifically, after reaching age 70.5, there is no need to calculate an RMD for the annuity. Instead, each year the payment from the annuity is simply considered to be the RMD amount.