Q: Geraldine asked this about her non-qualified variable annuity income. “Dear Derek: How do I know what portion of my annual income from this annuity is being taxed properly?
A: Great question, Geraldine! Since annuity payments from variable annuities will fluctuate based on the performance of the underlying investments, the payments are taxed differently than those from fixed annuities. The nontaxable portion of each payment is constant over the term of the annuity. It is calculated by dividing the investment in the annuity contract (adjusted for any refund feature) by the number of expected periodic payments. Any portion of each payment that exceeds this amount is taxable as ordinary income. If the annuity payment is less than the recovery portion of the basis, in later years the taxpayer may elect to re-compute the nontaxable amount. If such an election is made, then the portion of the basis that was not recovered in the earlier year is spread out over the remainder of the annuity contract term. Once the nontaxable portion (or basis) has been completely recovered, any additional annuity payments are fully taxable.
Example 2. Taxpayer (T) purchased a variable annuity for $150,000. T retires at age 70 and begins taking annuity payments based on his life expectancy. At this time, the value of the annuity contract is $200,000. T receives an annuity payment of $12,500 in the first year of the annuity. The taxable amount is calculated as follows:
Cost of the Annuity Contract $ 150,000
Life Expectancy Multiple for Age 70 from Table V 16.0 years
Tax-Free Amount for Each Payment ($150,000 / 16.0) $ 9,375
Amount Included in Ordinary Income ($12,500 – $9,375) $ 3,125
Example 3. Assume that the next year, the value of T’s annuity investments decline. Since T owns a variable annuity, the amount he receives is based on the value of the contract. In Year 2, T receives an annuity payment of only $5,000. Since this is below T’s nontaxable amount, none of it is taxable. Next, assume that in Year 3, the annuity investments have recovered in value and T receives $12,000. Therefore, his nontaxable amount that year is again $9,375. In addition, T may make an election to re-compute his excludable amount for the remainder of the annuity term because Year 2’s payment was less than his excludable amount. The amount of nontaxable recovery of basis that was not used in the previous year is allocated over the remainder of the recovery period based on T’s life expectancy at the time of the recalculation. T is now 72 years old, and therefore, has a life expectancy of 14.6 years under Table V.
= ($9,375 – $5,000) / 14.6 = $ 300
Thus, $300 of the nontaxable recovery of basis is added to the nontaxable recovery of the basis for each remaining year; giving T a nontaxable amount of $9,675 per year. Therefore, in the current year, T has a nontaxable recovery of $9,675 and an ordinary income of $2,325.
Geraldine, thank you for your question. I am sure many of your neighbors have had this question from time to time and I hope I did a good job providing some examples of how your distributions could be taxed in the future.