There's a safe (tax) harbor for those using annuities to sail through retirement

Recently, Jason Hamilton, Tax Partner in our Knoxville office, appeared on George Korda’s State Your Case radio show to take tax questions from the show’s listeners. One caller in particular has an annuity from which she receives a monthly return. She was wondering how difficult it is to determine how much of her monthly payment is tax-free, thus excluded from her tax return.

That's a good question, something which perhaps a good many annuity contract holders are unaware.

Somewhat remarkably, as we’re talking about taxes, in the case of this financial instrument it’s not as complicated as you might expect.

Here’s a good description of an annuity: “you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment.”

Using what’s called the Safe Harbor method, it’s a fairly straightforward calculation to see the tax-free (excludable) annuity amount. When you receive your annuity payment – from your qualified employee plan – to start the process you need two pieces of information: the age of the annuitant or annuitants (whoever holds the annuity contract and named parties) and your total investment in that annuity. (Note: if your annuity pre-dates Jan. 1, 1998, this calculation method is invalid because different rules exist for calculating the tax-free amounts of these annuities).

The primary employee’s age governs the number of payments received over the annuity lifespan. This chart illustrates the monthly payments an annuitant will receive, based on age:

Age of Primary Annuitant Number of Payments
55 and Under 300
56-60 260
61-65 240
66-70 170
71 and Over 120


A joint, or survivor annuity, has the total number of payments adjusted for multiple annuitants. In this case as well the total number payment is based on the employee’s age on the annuity starting date. It’s necessary to combine the annuitants’ ages to arrive at the total number of monthly payments. Use the following table to find the number of monthly payments over the duration of a joint or survivor annuity:

Combined Age of Annuitants Number of Payments
110 and under 410
Greater than 110 but less than 120 360
Greater than 120 but less than 130 310
Greater than 130 but less than 140 260
More than 140 210


When that’s determined, add into the equation the total investment in the annuity contract, including any applicable death benefit exclusion. Calculate it using this formula:

Investment     ÷     Number of monthly payments     =     Tax-free portion of monthly annuity

The tax-free portion is still excluded even if the amount of the monthly annuity payment changes.

If higher survivor payments result in the excludable amount being larger than the monthly annuity payment, each payment is excluded completely until the entire investment is recovered. Furthermore, if the annuity payments cease before the set number of payments has been made, the annuitant can make a deduction on his or her last tax return for the unrecovered amount of the investment.

Finally, the payment is taxed under different rules if in connection with the start of annuity payments the annuitant receives a lump-sum payment that isn’t part of the annuity stream.

If you’re using an annuity as part of your retirement it’s good to know – if you didn’t already – that this tax advantage exists. It was a good question from the radio show caller – with a happy answer.



Tagged Annuity, Featured, Safe Harbor, Taxes