How Are Nonqualified Variable Annuities Taxed?

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How Are Nonqualified Variable Annuities Taxed?

What Is a Nonqualified Variable Annuity?

Nonqualified variable annuities are tax-advantaged investment instruments having a one-of-a-kind tax structure. While you will not get a tax deduction for your contributions, your account will grow tax-free until you remove it, either via withdrawals or as a monthly income in retirement.

Key Takeaways

  • Nonqualified variable annuities do not provide a tax benefit for donations, but your investment grows tax-free.
  • When you make withdrawals or start receiving monthly payments from the annuity, the money is taxed as ordinary income.
  • In most situations, any money you remove before the age of 5912 will be subject to a 10% early withdrawal penalty.

How a Nonqualified Variable Annuity Works

Variable annuities function similarly to the majority of annuity contracts issued by insurance companies. The insurer offers to give you a regular stream of income in exchange for the money you invest, typically starting at retirement age and continuing for the remainder of your life.

A qualified annuity is a form of retirement plan, similar to a standard individual retirement account (IRA), that allows you to deduct your contributions up to Internal Revenue Service (IRS) restrictions. Nonqualified annuities, on the other hand, are not considered retirement accounts for tax reasons and do not give you a deduction—even if you use them to save for retirement.

Contributions to a nonqualified variable annuity are made using after-tax monies, just like any other investment outside of a retirement plan. Your payments are then invested in subaccounts, which are akin to mutual funds, of your choice by the insurer. The annuity’s value will fluctuate depending on the success of the assets you choose. In contrast, with a fixed annuity, the insurer selects the assets and guarantees you a specified return.

Although a nonqualified annuity does not provide an immediate tax savings, the gains on your subaccounts grow tax-deferred. This is the one-of-a-kind tax benefit of annuities. Other nonqualified accounts, such as a brokerage account or mutual fund, tax the interest, dividends, and capital gains distributions generated by your investments in the year you receive them. That is true whether the money is taken in cash or merely reinvested.

  Taxation Defined, With Justifications and Types of Taxes

Only when you withdraw money or get income from the insurer during the payment phase of the annuity do the profits in your variable annuity account become taxable. The money you get is then taxed at the same rate as your regular income.

Tax on Withdrawals and Income

Only your net gain—the gains on your investment—is taxed when you receive money from a nonqualified variable annuity. Because you made your contribution to the annuity using after-tax cash, it is not taxed. As a consequence, for tax purposes, a part of each payment you get is considered as principle (that is, a return on your investment in the contract).

How is this determined? Essentially, the nontaxable component of each payment is determined by the contract investment to account balance ratio. To be more specific, the tax-free and taxable components of annuity payments are calculated using a particular formula described in IRS Publication 575.

On Form 1099-R, the insurance provider will disclose the total yearly payments to you and the IRS. Typically, the form will also display your taxable amount, so you won’t have to calculate it yourself.

Taxes at Death

The variable annuity contract may provide that a person you designate as a beneficiary will get a lump-sum death benefit if you die. Some taxes may be required when a death benefit becomes payable to a recipient, depending on the conditions of the contract.

Despite the fact that this is an inheritance, the recipient is required to pay income tax on the percentage of the payment that exceeds your remaining investment in the contract. This is the portion of your contract cost that was not recovered after all payments and withdrawals were made over your lifetime.

It also matters if the beneficiary is your spouse or someone else.

  What Is Use Tax?

Spouse Beneficiaries

In most cases, a spouse who inherits a nonqualified variable annuity has the choice to continue the contract in their own name. By selecting this option, the spouse avoids paying taxes until they begin making withdrawals. If the spouse elects to receive a lump-sum death benefit, the profits are immediately taxed as ordinary income.

Other Beneficiaries

Depending on the conditions of the contract, beneficiaries who are not spouses often have three options: take a taxable lump-sum payout (as noted above), withdraw the money over a five-year period, or accept distributions based on the beneficiary’s life expectancy. The disbursements must commence within one year following the death of the original account owner.

If you need to cancel the contract early, variable annuities can include substantial costs, including surrender charges.

Other Considerations

Other problems to consider with variable annuities, whether qualified or nonqualified, other from the fundamental tax requirements.

Fees

Variable annuities include significant fees, including an insurance charge that covers any guaranteed death benefit as well as an administration fee. These costs are based on a percentage of the contract’s value and are applied annually. Depending on the insurance provider and other conditions, they may average 2% or more every year. These sums are not deductible as investment expenditures. They constitute part of your contract cost (investment).

Additional Taxes

The taxable component of variable annuity income must be included in the calculation of the 3.8% extra net investment income tax for high-income taxpayers.

Early Distributions

Variable annuity withdrawals of any form, whether a single withdrawal or a stream of monthly payments, made before age 5912 are subject to a 10% early withdrawal penalty on the taxable component of the payment, just like other tax-deferred funds designed for retirement.

If you are entirely and permanently incapacitated, the penalty does not apply. It also does not apply to a beneficiary who gets payments after your death, regardless of age.

  Retirement Accounts Abroad

Surrender Charges

If you “surrender” the contract, which involves cashing it in before you begin receiving annuity payments, the insurer may levy a substantial surrender fee. The part of the money representing your investment in the contract is tax-free, but any excess is taxed as regular income. You may deduct a tax loss if you get less money than you put into the contract after deducting the surrender fee.

Exchanges for Other Annuity Contracts

Instead of cashing out a variable annuity to purchase one with better conditions (such as cheaper yearly fees) and paying tax on the difference, you may move to another contract in what is known as a 1035 exchange. The exchange is tax-free as long as the annuitants in both contracts are the same.

Withholding

The insurance company will automatically withhold taxes on the taxable part of your annuity payments at the same rate as if you were married and had three withholding allowances (even if you are single).You may, however, opt out of withholding by submitting IRS Form W-4P.

The Bottom Line

Variable annuities might be appealing from a tax standpoint because of the deferral provision, which enables you to delay tax on your investment profits. However, you or your beneficiaries will have to pay tax on the income produced under the contract at some time. Furthermore, the tax will be at your ordinary income rate rather than the more advantageous capital gains rate you’d pay if you invested in a normal taxable account.

It is essential to get expert tax guidance before withdrawing from a nonqualified variable annuity or inheriting money from one. A bad choice might result in a big tax charge.

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