Determining the many different annuity fees and taxes requires some careful study and a lot of questions. For simplicity’s sake, fees and taxes can be divided into two categories: standard fees and taxes, and penalty fees and taxes.
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Annuities are attractive investments for retirement purposes, but they are also complicated investments subject to a maze of state and federal regulations. This article will review the accumulation and surrender periods, taxes and penalties that contribute to the overall cost of an annuity.
The Annuity Accumulation Period
Annuity contracts are structured in such a way as to take contributions from the investor for a predetermined period of time. This is called the accumulation period. Contributions to the annuity may be made as a lump sum or incremental payments during this time.
The accumulation period is designed to get as much money onto the policy as quickly as possible. This is to allow the issuer the maximum amount of time to earn a return on the money the distribution begins. For this reason, withdrawals made during the accumulation period are discouraged by penalties. Many annuities will allow up to 10% of the current value to be withdrawn annually without incurring a fee. Any withdrawals above that amount are subject to penalties as high as 10% of the amount taken out.
If your annuity contact contains a surrender period, you are essentially agreeing not to withdraw any amount from the policy during that period. Typically, surrender periods don’t exceed 10 years. Any withdrawal during the surrender period is likely to incur a minimum penalty of 10%. Surrender period penalties don’t apply to withdrawals under certain conditions, such as the death of the owner. Check your individual policy for a list of exceptions.
The tax law is structured to allow contributions to an annuity to be tax-free until the time of withdrawal. The price of such a benefit is that annuity holders must leave their investment alone until age 59 ½. The government has structured things this way in order to encourage investors to keep the money invested until retirement age, thus lessening the burden on Social Security.
Withdrawals made before age 59 ½ are subject to a 10% federal penalty. In addition, those amounts will be immediately subject to income and capital gains taxes, where applicable.
The death of the annuity holder triggers a mandatory disbursement according to federal regulations. Early withdrawal penalties are not assessed by the IRS for such payments. Estate taxes, however, will still apply.
If ownership of an annuity is transferred to another party, say a spouse or a child, certain IRS taxes and penalties may apply depending on the circumstances of the transfer. Examples of such taxes and penalties include the gift tax, the standard 10% penalty for early withdrawal, and normal taxes paid on earnings.
Taxes During the Annuitizing Period
The annuitizing period of an annuity contract is the back end, when the policy holder begins to receive his guaranteed payments. Such payments are subject to normal income tax, and are penalty free if received after age 59 ½.
Taxes in annuitized payments are calculated according to the last in first out (LIFO) principle. That is to say, the last contributions to the account are the earnings you made off the investment. Withdrawals are made against these earnings until they are all gone. Such earnings are taxed both as income and capital gains.
Once earnings have been exhausted, disbursements on principle are taxed as normal income. Payments made to a beneficiary upon the death of the policy holder are subject to income and estate taxes as long as they continue. Estate taxes will be assessed based on the total value of the remaining payments.
Annuities Held in Trust
Occasionally, upon the death of an annuity holder, ownership of his or her policy is transferred to a trust. The beneficiaries of that trust may or may not receive material disbursements from the annuity at a later date. At issue however, is whether or not a trust is subject to the same taxation as a natural person.
Trusts have traditionally been held as “non-natural” persons by the IRS for purposes of taxation. To avoid the abuse of annuities by those who would transfer them to trusts, the IRS ruled that the non-natural persons rule does not apply to annuities. An annuity policy held in trust is subject to the same tax and penalty rules as a natural person.
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