The exclusion ratio also takes into account the income option you select—whether it’s lifetime payments, payments for a set number of years, or joint-life payments in which a surviving spouse receives the benefits after the account holder's death. "All of which," says Michael Harris, senior education advisor at the Washington, D.C.-based Alliance for Lifetime Income, "help determine your monthly income check. The insurance company will provide a 1099 at the end of the year with all the associated tax information."
A Tax Planning Tool
A key advantage of the exclusion ratio is that it allows you to "spread out the taxes until the basis is exhausted," says Gary Schwartz of Madison Planning in White Plains, N.Y.
This can be "a powerful tax planning tool to reduce the impact of taxes on distributions," says Laird Johnson, senior director of advanced markets at Equitable in New York City. He adds that the exclusion ratio is often mistakenly thought to apply only to fully annuitized contracts. "Some products allow for partial or term-certain annuitizations that provide the tax benefits of the exclusion ratio without full annuitization," says Johnson.
Annuitization Disadvantages
If all of the principal is paid out, any additional distributions are taxed as ordinary income. Similarly, if the annuitant outlives his or her life expectancy, all payouts thereafter are taxed as ordinary income, too.
"The disadvantage of doing an annuitization is that once you annuitize, the election is irrevocable, and most contracts don’t have a cost-of-living adjustment rider," says Luis Strohmeier, a partner and wealth advisor at Octavia Wealth Advisors in Miami. "So once you make the election, it’s the same income amount [for the contract's term]. This is in contrast to a withdrawal rider, which is not an irrevocable election and can be simply withdrawn from the account value."
Inheritance
When the contract owner dies, the heirs will be taxed on distributions in the same ways. But for nonqualified annuities, non-spousal beneficiaries "are required to begin taking distributions … within one year of the original owner’s death," explains Eric Henderson, president of Nationwide Financial’s annuity segment in Columbus, Ohio. "If the beneficiary does not take the required amount within one year … they have five years from the date of the owner’s death to liquidate the entire inherited annuity," he says. (Spouses who inherit nonqualified annuities "may continue the annuity in their own name and are not required to take distributions," says Henderson.)
If the non-spouse beneficiaries do take the required withdrawal in the first year, though, they can spread out remaining payments—and, therefore, forestall taxes. "Under current tax law, a beneficiary of an annuity can opt to stretch payments over many years, based on the beneficiary’s life expectancy," says Todd Hall, director of financial planning at Homrich Berg in Atlanta. "This was previously available for those inheriting an IRA as well, but recent tax law changes eliminated that option."
On the other hand, if it's a qualified annuity, non-spousal beneficiaries must withdraw all funds within 10 years. The tax rules on those withdrawals are the same, but the extra time should be enough to "manage how to efficiently take the distributions out so they're not all taxable at once," says Ben Barzideh, wealth advisor at Piershale Financial Group in Barrington, Ill. "If they don’t take anything out for the 10 years … then at that 10th year they have to take a full distribution of the amount and what it has grown to. That could be a tax disaster."
The inheritance rules do not apply if the annuity is gifted to someone (other than a charity) while the original owner is still alive. Such transfers trigger a taxable event for the donor.
Legacy Planning
With an inherited annuity, there is no "step up" in the cost basis, as there would be for long-held stocks or real estate. Yet Brandon Buckingham, vice president of advanced planning at Prudential Financial in Boston, points out that annuities "can have several benefits from a legacy planning perspective."
One advantage he cites is that they aren't subject to probate and the associated expenses and delays. Beneficiaries can defer taxes by not completely cashing in inherited annuities all at once. And many annuities offer enhanced death benefits, which work like life insurance.