Taxation of Immediate Annuities
An immediate annuity is a contract with an insurance company to provide a lifetime or fixed period income to the annuitant. The contract buyer, or annuitant, gives the insurance company a lump sum of money and the insurance company provides a guaranteed income. Immediate annuities can be purchased with non-tax-qualified money that provides a tax-advantaged income.
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Considerations
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Tax-qualified money is from retirement plans and IRAs. If qualified money is used to purchase an immediate annuity, the tax rules for those types of plans will apply. A non-qualified immediate annuity is purchased with money from other sources such as savings or investments. The immediate annuity purchased with non-qualified money pays a tax-advantaged regular income.
Function
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An immediate annuity is usually purchased to provide a lifetime income to the annuitant. The annuity will pay a regular monthly or annual check until the annuitant dies, whether it is in a few months or after 40 years. Immediate annuities have options that will guarantee a minimum payout or payment for a minimum number of years if the annuitant dies early. Annuities will usually provide a higher level of income than CDs or bonds because the principal amount is paid to the insurance company and will not be returned. The annuity provides an income that cannot be outlived.
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Significance
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The Internal Revenue Service considers immediate annuity payments a partial return of principal plus interest. The principal value is divided over the life expectancy of the annuitant at the time the annuity payments are started. For example, if the IRS life expectancy tables showed the annuitant had a 20-year life expectancy, the amount paid for the immediate annuity would be divided by 20 and that amount would be excluded from taxable income on the annuity payment. If the annuitant lives longer than the computed life expectancy, the annuity payments will become fully taxable.
Identification
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The insurance company that quotes an immediate annuity will show the monthly or annual payment for the amount of annuity purchased and an exclusion percentage or amount. The exclusion percentage is the portion of each annuity payment excluded from income taxes. Subtracting the exclusion amount from the annual payment will provide the amount of taxable income from the immediate annuity.
Benefits
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For retirees looking for a steady income from a lump sum of money, an immediate annuity has several advantages over other alternatives. The monthly payment amount will usually be higher than other investments and guaranteed by the issuing insurance company. A large portion of the annuity payment will be exempt from income taxes, boosting the after-tax income compared with other investments.
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References
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