Tax on Annuity

[Ronstar]

I invested in an annuity about yrs ago (at the advice of my accountant)

Now I'm either going to:

1. Annuitize for 10 years
2. Cash it in.

I'm not considering a lifetime payout. My initial thoughts are that I can get a better return by cashing it in or at least by minimizing the payoff term of the annuity. And for the sake of comparing to a cash out, the 10 year payoff seems to present a good option for comparison.

I'm trying to figure out which alternative would be the best financially. In doing so, I set up a spreadsheet where I computed the future value of the annuity payments if I were to invest them at x%.

I did the same for a lump sum payout (minus 15% cap gains tax on the gain), invested at x%.

Given this, I need a rate of return of at least 4.8% over 10 years for the cash out to make sense. Seems high to me.

But I have not computed the taxes on the gains in each scenario for the 10 years in the comparison.

I imagine that the taxes on the annuity pmts are a blend of ordinary income and cap gains. Probably a blend of cap gains/ ordinary income in 10 years of investment income in the cash out option- but a different blend than the pmts option.

My question is - Will the taxation difference on the 10 years of investment returns between these 2 options be significant enough to consider in deciding which option to take?

 

[Independent]

I think it works like this:

The gains in an annuity are taxed as ordinary income, not as capital gains.

If you take all the money as a lump sum, you pay tax on the excess of the lump sum over your premium.

If you set up a level periodic payment over a fixed number of years with the company, each payment is treated as a mix of principal and gain, with the mix equal for each payment. See "Fixed period annuity" here: https://www.irs.gov/publications/p939/ar02.html#en_US_2013_publink100094769

(That publication also covers a life annuitization, but you aren't interested in that.)

If you withdraw money in some other pattern, you are subject to a "gains first" rule.

 

[Sandy & Shirley]

We are in the same situation with Shirley’s Annuity. For the sake of conversation, let’s say that she has a single $100,000 annuity. It has a current annuity value of $123,000 and a cash value of $107,000. The annuity value will continue to grow by 7% each year while the cash value grows by maybe 2% to 5%. The conversion value also grows by about 2% each year which means that the lifetime payout is growing by 9% a year.

If we start the annuity next year she will get $7,000 a year for the rest of her life. That $7,000 is taken from the cash value each year which is also her death benefit. The $7,000 will continue even after the death/cash value goes to zero.

If we wait an additional 8 years to convert the annuity to lifetime income, the death benefit will continue to grow and the annual payout will double from $7,000 a year to $14,000.

We refer to her annuities as one of the best horrible investments we have ever made. Horrible because of how slow the cash value grows and best because of the guaranteed lifetime income backed up by the death benefit.

 

[Alan]

I think it works like this:

The gains in an annuity are taxed as ordinary income, not as capital gains.

If you take all the money as a lump sum, you pay tax on the excess of the lump sum over your premium.

If you set up a level periodic payment over a fixed number of years with the company, each payment is treated as a mix of principal and gain, with the mix equal for each payment. See "Fixed period annuity" here: https://www.irs.gov/publications/p939/ar02.html#en_US_2013_publink100094769

(That publication also covers a life annuitization, but you aren't interested in that.)

If you withdraw money in some other pattern, you are subject to a "gains first" rule.

I think this is exactly how it works.

 

[Ronstar]

I think it works like this:

The gains in an annuity are taxed as ordinary income, not as capital gains.

If you take all the money as a lump sum, you pay tax on the excess of the lump sum over your premium.

If you set up a level periodic payment over a fixed number of years with the company, each payment is treated as a mix of principal and gain, with the mix equal for each payment. See "Fixed period annuity" here: https://www.irs.gov/publications/p939/ar02.html#en_US_2013_publink100094769

(That publication also covers a life annuitization, but you aren't interested in that.)

I think this is exactly how it works.

I just had a visit from DW's FA. He said the same thing - gains taxed as ordinary income. I don't think I'm going to cash it in - I'll just take the 10 year payout.

Independent - Thanks for the link to the publication.