Understanding the Annuity Aggregation Rule
Annuities provide tax-deferred growth and pay guaranteed income during retirement. If you own an annuity, then it’s good to know how to pay taxes on your withdrawals.
Of course, your annuity carrier will send you a statement at the end of the year showing how much you need to report as taxable income. Nevertheless, knowing what to expect can save you from an unpleasant surprise when you file your tax return. That is especially the case for non-qualified annuities, in which your funds aren’t subject to required minimum distributions. For that reason, tax hits on your non-qualified annuity withdrawals may be a little less familiar territory.
This article on annuities and taxes is a great starting point for understanding the fundamentals of how annuities are treated under different parts of tax law. In this article, we will focus on more on a breakdown of the tax rules for non-qualified annuity withdrawals.
There is one little-known rule that affects you if you own more than one non-qualified annuity, and that is called the “aggregation tax rule.” Let’s get more into that in a little bit.
Non-Qualified Annuities and One-Time Distributions
The tax rules for non-qualified annuities can be pretty involved. If you take a one-time distribution from a non-qualified annuity, then it will be taxed on a Last-In-First-Out (LIFO) basis. This means that your distribution will be considered to come entirely from earnings.
For example, say you put $100,000 in a fixed indexed annuity 20 years ago and now the annuity is worth $275,000. If you are now retired and want to draw $75,000 out of your annuity to pay off your mortgage, the entire $75,000 will be taxed as ordinary income, because this money will be classified entirely as earned interest.
How Periodic Distributions from a Non-Qualified Annuity Are Handled
Periodic distributions (in other words, more than just one time) are taxed somewhat differently. If you annuitize your annuity contract, or you convert your annuity money into an irrevocable stream of income, then your life insurance carrier will calculate the amount of taxable income in your payout according to a formula known as the exclusion ratio.
This ratio equals the amount of money that you originally put into your annuity divided by the total annuity balance.
For example, if you put $100,000 into your annuity 20 years ago as noted above, and then you decide to annuitize your contract, a portion of each payment you receive will be considered a tax-free return of principal. In this case, assuming that your current annuity value is $275,000 like in the example above, then your exclusion ratio will be calculated according to your life expectancy.
If you are 65 years old now and your life expectancy is 83, then your insurance company will spread the return of your principal over the next 18 years. The amount that you will pay tax on with each payment is calculated as follows:
$100,000 principal / 216 months (18 years x 12 months) = $462.96
$275,000 total annuity balance at age 65 / 216 months = $1,273.15 total monthly payment
Therefore, $462.96 of each payment of $1,273 will be considered a tax-free return of your original investment. Each payment of $810.19 will be taxable.
If you live past your life expectancy (age 83 in this case), then any additional payments that you receive will be classified as fully taxable. Why? By that time, you will have depleted your principal in the annuity contract and are now essentially living off the insurance company’s money (at least partially).
The Aggregation Tax Rule
There is another rule created by the IRS back in 1988 that also affects non-qualified annuities. This rule is called the “annuity aggregation rule,” or “aggregation tax rule.”
It says that if you buy more than one deferred annuity of any kind from the same insurance company within the same year, your withdrawals will be aggregated for the purpose of calculating the tax that you owe.
Say you bought two $100,000 annuities from the same insurer within the same year and each annuity earns $5,000 over the next year. At the end of the year, you decide to withdraw 10% of the balance from one of your annuities, which comes to $10,500 ($100,000 + $5,000 x 10% = $10,500).
If this annuity was the only one you owned, then the tax would be calculated on the LIFO basis. The full $5,000 of gain would be realized as fully taxable income with the remainder ($10,500 – $5,000 = $5,500) being classified as a tax-free return of principal.
But since you own two annuities with the same insurer, your tax will instead be calculated as follows:
$5,000 earnings x 2 = $10,000
Total withdrawal from one annuity = $10,500
Taxable income from this withdrawal = $10,500
In this case, the earnings from both annuities must be considered when computing the tax liability. But this annuity aggregation rule only applies when someone buys more than one deferred annuity from the same life insurance carrier within a single year.
If you and your spouse buy separate annuities from the same carrier, but each contract is in each of your names only, then this rule won’t apply. The aggregation rule also won’t apply if you buy a deferred annuity and an immediate annuity from the same company in the same year.
What Else Should You Know About the Annuity Aggregation Rule?
All of this said, some insurance companies go by a calendar year. Others use a fiscal year, which may start on the date that you start your first contract.
So, if you buy an annuity from ABC Insurance Company on June 11, 2023, and then buy another one from the same company on February 3, 2024, the aggregation rule may or may not apply to you based on when the company says “your” year begins.
If ABC Insurance Company uses a calendar year, then the rule won’t apply, as you bought one contract in 2023 and the other one in 2024. If the company uses a fiscal year that starts in March, then the rule would apply, because you bought both your contracts within that one-year period. The same thing goes if the insurance company starts your fiscal year on June 11, 2023.
Applying the Aggregation Rule to Annuity Distributions
The aggregation rule applies regardless of whether you take a one-time distribution or a series of periodic payments. Building upon the example above, if you leave one of your annuities alone and annuitize your other contract (and it doesn’t matter which annuity), then the exclusion ratio will count the untapped earnings in your non-withdrawal contract as taxable income as well.
Of course, the easy way to get around the aggregation rule is to simply buy your annuities from different insurers. Otherwise, you can make sure that each annuity from the same company is owned by a different party, such as you, your spouse, or a trust.
The aggregation rule is normally only a factor to consider for folks who open a series of annuities over the course of a calendar or fiscal year and then start taking laddered distributions from them.
If this is the case for you, then you should talk to your tax or financial advisor about the ramifications of your strategy. You can also download Publication 575 from the IRS website.
Can You Count on Dependable Income in Retirement?
Even with the aggregation rule, annuities can be a great way to plan for retirement. They are the only type of financial vehicle that can pay you a guaranteed stream of income for life, even if the money in your contract has hit zero.
Depending on what you need, an annuity might be able to help with other financial goals with its contractual guarantees as well. Your money will grow tax-deferred inside the annuity until you retire. Your financial advisor can show you the benefits that an annuity can provide for you (as well as the pros and cons for your situation).
Are you looking for a financial professional to help you explore different options for generating retirement income or growing your retirement money with tax advantage? Perhaps you have a current retirement strategy and would like a second opinion on it.
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