Fixed Index or Equity Indexed Annuities Tax Implications

Fixed index annuities provide a mixture between a fixed annuity and a variable annuity.  They pay interest at a rate that fluctuates with market conditions, but the fluctuation is capped on either end: it will not lose value is the market declines, but it also will not return as much as the market does in good years.  Holders of a contract for a fixed index annuity get some of the benefits of market appreciation and the stability of an investment that will not lose value.

Applying this overview of the fixed index annuity to the tax treatment of annuities, it becomes clear that a fixed index annuity will provide a slightly less predictable tax situation than a fixed annuity.  Retirement annuities all share a common principle of taxation: they grow tax deferred during the life of the annuity, and when payments are made there is no taxation on principle, but there is taxation on interest.  This is true regardless of whether an annuity is a fixed annuity, variable annuity, or a fixed index annuity.

The mechanics of calculating and recording the tax due on a fixed index annuity is not substantially different from any other type of annuity.  The company that holds the annuity contract will notify you and the IRS of how much interest they paid you in a given year.  Where the fixed index annuity adds work to your retirement planning is in predicting taxable income from year to year.

Because interest is taxed and principal is not, in any given year the amount of the annuity that is taxable will vary in the case of either a variable or fixed index annuity.  In either of those cases, the annuity company will calculate the total amount of principal that you contributed during the accumulation phase of the annuity and divide it by the number of months that you will receive payments.  In the case of a fixed term annuity, that number is the number of months called for in the contract.  In the case of an annuity for life, the annuity company will use a life expectancy table from the IRS to determine the number of months that the annuitant is expected to live.  Once the amount of principal per distribution period has been established, then anything over that amount is interest.  It is reported as, and taxed as, ordinary income.

For annuities since 1982, any additional amount paid above and beyond the scheduled principal repayment is treated by the last-in first-out theory.  This means that any additional amount paid, in the event that a variable payment is made, is treated as interest income, not repayment of principal.

For many retirees, these rules pose no significant problem.  But for some, especially for higher income retirees, additional interest payments in a year might cause other tax problems.  For example, taxation of social security benefits is phased in for higher income taxpayers, as is the alternative minimum tax.  An unexpectedly large interest payment in a retirement year could cause an unexpected tax bill due to either of those rules.  In addition, once the AMT applies, there are certain limitations on other deductions, and some tax-free bond mutual funds stop being tax-free.  (Check to see how much of your tax-free bond funds are also AMT tax free.)

If you have decided that an annuity is for you, and want to benefit from some of the market upswings without the risk of market downswings, a fixed index annuity might be a choice.  But be prepared to spend more time talking to you accountant or tax preparer than you would otherwise spend, and keep a close eye on your tax liability throughout the year to avoid any unexpected tax bills on extra interest.