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Annuity Taxation Rules

Because taxes are one of life's two certainties, the tax man will eventually get his share of virtually every investment that you make. While there's no legal way around this fact of modern life, a number of investment mechanisms offer tax deferred earnings, meaning investors are only taxed on investments when they withdraw funds. Annuities are one of these financial instruments and allow investors the opportunity to delay taxation and reduce their taxable income. This information is current as of tax year 2010.

Tax Deductions and Deferment

Contributions to an annuity aren't deductable on taxes as are other retirement accounts such as IRAs or 401k plans, though there's no cap on the amount which may be paid into an annuity each year. Interest earned from annuities isn't taxed until it is withdrawn from the amount. Over the life of an annuity, the extra principal in an account may make a large difference in returns, as money that would have been devoted to paying taxes continues to draw interest. Like IRAs and 401k plans, however, any money withdrawn from an annuity before the beneficiary turns 59 1/2 years old may incur a tax penalty.

Taxation on Lump-Sum Distributions

When an annuity pays the entire principal to the investor upon maturity, it's called a lump-sum distribution. Taxation on lump-sum distribution is straightforward. Only the amount of interest made while the annuity matured is taxed at normal income-tax rates. For example, when distributing an annuity that was based on a $100,000 investment that matured at a value of $150,000, only the $50,000 of profits will be taxed.

Taxation on Annuitized Distributions

Other forms of annuity return their investment in incremental sums to the investor. This form of payment is called annuitized distributions, and is taxed using the same formula as lump-sum distributions, where only profits are taxed. However, because of the extended withdraw system, investors must calculate how much the annuity will generate in its lifetime. The initial investment amount is divided by the annuity's final value to calculate the annuity's exclusion ratio. Once an exclusion ratio is established, beneficiaries are only taxed on the ratio of each distribution that's income. For example, a $100,000 investment into an annuity that will have a lifetime value of $150,000 has an exclusion ratio of 0.66 (100,000/150,000). Each time a beneficiary receives a distribution, 66 percent of it will not be taxable.

Taxation Rates

When holders of IRAs and other mutual funds' profits are taxed, the IRS taxes them on a gains tax rates. Annuities are taxed as normal income, which is taxed at a steeper rate than gains. Both gains and income tax rates float by the amount of the gain or amount of personal income each year.

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