How Much Tax Will I Owe On My Income Annuity?
As you well know from a lifetime of working, income taxes can make a real impact on your monthly budget, so no plan would be complete without factoring in this important detail.
The way income is taxed is quite different from many other investments and, even, other annuities. In fact, the tax burden can be much lighter than dividend distributions from stocks or bonds.
When you buy an income annuity with after-tax savings (i.e., with so-called "non-qualified" monies), the IRS recognizes that that money has had taxes already paid on it.
For this reason, as you receive each month's payment from the annuity, you are only taxed on that portion of each payment which represents new earnings: meaning, the new interest your annuity is generating (above the principal you receive). You are not taxed a second time on the portion of each payment which represents a return of your previously-taxed principal.
This approach to calculating the taxes on your annuity is called the "exclusion ratio" or "pro rata" method and it's computed using the IRS General Rule (see IRS Publication 939). You can read more about the Rule on the IRS site.
When you receive quotations for immediate and deferred income annuities, you will notice a section listing the taxable portion of your annuity payment. If you'd like to understand how the insurance company determines which portion of your payments should be taxable, I can walk you through an example.
Referring to Table V in IRS Publication 939 (see page 26) we find the so-called "multiple" for age 65 to be 20. This word, "multiple," is how the IRS refers to your life expectancy. In other words, the IRS expects a 65 year old to live for 20 years.
So, if you multiply your monthly income (which we assumed to be $550) by 12 months you compute an annual income of $6,600. Next, we take this annual income figure of $6,600 and multiply it by the IRS life expectancy "multiple" of 20 and get $132,000.
So the IRS assumes that a 65 year old will receive $132,000 ($6,600 x 20) over his lifetime based on a $100,000 annuity investment. How much you actually receive will depend on your health and longevity.