Annuities are contracts between you and an insurance company that provide guaranteed payments for the remainder of your life. You may also be able to add survivor benefits for an extra cost. The taxes on your earnings are deferred until you start taking withdrawals from the account. You can sell an annuity contract just like any other investment. If the sales price is higher than your cost basis in the annuity, you will have taxable income to report at the end of the year.
Start with the amount of money you originally deposited to open the annuity. Because you have already been taxed on this when you earned the income, your deposit becomes the cost basis of your investment. If you deposit more into the annuity over the years, add these deposits to your total basis.
Adjustments to Basis
Once you have determined the original cost basis of the annuity, you must make certain adjustments before you can calculate your gain. Do not include any money you paid for additional endorsements and riders. Look up your withdrawal history or request the information from your annuity provider. Subtract these withdrawals on a last-in, first-out basis. Withdrawals must be taken out of your tax-deferred earnings first.
Gain on the sale of an investment would normally be a capital gain, but the Internal Revenue Service considers the sale of annuities to be ordinary income. Taxpayers prefer being able to claim capital gains, because the tax rate is capped at 15 percent. The ordinary income tax rate is the same as the rate you pay on wages, interest, dividends, retirement plan distributions and other types of income. The maximum tax rate for ordinary income is 38.6 percent.
Check the annual report from your annuity company against your records. The annuity company will also be reporting this information to the IRS, so you must request a corrected copy before filing your personal tax return. You will receive a 1099 form on or before Jan. 31 of the following year if you took any withdrawals during the tax year. The gross distribution will be listed in Box 1 and the taxable amount will be listed in Box 2a. Your cost basis should equal the difference between these two amounts. You may also be able to request the cost basis from your annuity company in the middle of the year if you are thinking about selling your contract. This helps you evaluate whether the sale price is adequate to cover your taxes.
Section 1035 Rollovers
Cost basis accounting gets more complicated if you have executed a Section 1035 tax-free rollover, especially if two different insurance companies are involved. If the basis is not transferred over to the new insurance company, your 1099 form will show a zero basis. Call the second insurance company as soon as your transfer is complete to verify the cost basis it has listed for you. It is easier to correct any problems right away than to wait until you sell the annuity a few years later.
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