Tax Advantages Of Annuities

Many times annuities are purchased for their tax advantages, both real and potential. One advantage is that the interest earnings on deferred annuity premiums are not reportable as income during the year earned. However, they are reportable when actually received. Because the annuity benefits are usually paid during retirement, the individual likely will be in a lower tax bracket and will be able to take the retirement credit and a double exemption. The result is a reduced tax during high income years because a portion will have been deferred to a period of lower taxable income. 

There is also a significant tax advantage if the individual lives a long time. Only a portion of the annuity payments received each period is taxed as income. The “exclusion ratio” determines the amount of such taxable portion. To obtain the exclusion ratio, the individual’s investment in the contract at inception of the annuity is divided by the expected return under the contract. This “expected return” is based on the life expectancy of the annuitant at that time. It is approximately equal to the annual annuity payment multiplied by the number of years which the annuitant is expected to live. This ratio is applied to the total annuity income received each year regardless of the number of years in which it is received. Only the amount of income received in excess of the exclusion ratio is taxable each year. If the actual return is more than the expected return (i.e., the annuitant lives longer than expected), he, in effect, receives a certain amount of tax free income.