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Tax on Variable Annuity- Facts You Need to Know Before Investing

By Manjumodiyani @HoshiyaarChaddi
Annuity is an investment product and an important tool for retirement planning, offered by the insurance companies. It is a contract wherein the investor invests a lump sum with the insurance company, and gets a stream of payments in the form of payouts for a specific number of years, or for the rest of their life.Variable annuities have an underlying asset or security like stocks, bonds or commodities. The value of these underlying securities at a particular time determines the annuity rate, i.e., the rate of interest on the investment.
Tax on variable annuity- Facts you need to know before investing
1. What are types of variable annuity?
There are two popular types of variable annuities explained as follows.
i. Immediate variable annuityThis is a contract between the client and the insurance company, wherein the payouts start immediately when the lump sum amount is invested. This type of annuity is preferable for people who have already retired or are nearing retirement age.
ii. Deferred variable annuityThis is a contract between the client and the insurance company, wherein the lump sum amount stays invested for a period of time and grows tax-deferred. This period of time during which the funds are kept invested is called as maturity period. Longer the maturity period, the higher the annuity rate offered.  Maturity period ranges from 5 to 25 years. When the maturity period expires, the client starts receiving payouts on a monthly, quarterly, half-yearly or yearly basis, as may be specified by the client at the time of contract.
iii. Variable life annuityVariable life annuities are the contracts that offer to the clients the protection against the possibility of outliving the funds in the later life, by providing a regular income to the clients throughout their lifetime.
iv. Variable term annuityIn this type of variable annuity the contract is annuitized for a specific number of years. The stream of payouts lasts only for the fixed number of years, say for ten years or fifteen years. The client may run a risk of outliving his funds in the later life.
2. Tax implications on variable annuities
i. Capital gain is taxed as ordinary income
• Variable annuities are sold as the investment products that offer substantial tax savings by deferring taxes on the income generated on the investment in such annuities. The income can be in the form of interest, dividend or capital gain, and is not subject to income tax, until such time as the client starts receiving payouts.
• For example, if a client invests in bonds and receives interest income. He has to pay taxes every year, on this interest generated from the investment in the bonds.
• However, if the client invests in bonds under the variable annuity, the interest income will not be subject to taxes, until such a time as he starts receiving payouts.
• This happens because it is considered that the when the client receives payouts, gains are being paid out first, unless it is specified in the contract that the client wishes to annuitize the contract, which means he is investing a lump sum in order to receive a guaranteed stream of income.
• The income generated from the investment in the variable annuity is taxed as ordinary income. Rates of income tax are substantially higher than those of the capital gains tax. The client may end up paying up to 20% more taxes, which beats the very purpose of investment in variable annuity.
• This is a reason to worry especially for the clients who buy annuities having maturity period of ten to fifteen years. This period may not be sufficient for the tax deferral to cover up the losses that may occur due to hefty taxes in the event of withdrawals as well as to provide benefit.
ii. Event of death of the client
• If the event of death of the client occurs prior to any withdrawals, the funds will be received by the beneficiaries specified in the contract. The beneficiaries will have to pay taxes on the income from the annuity at ordinary income tax rates.
• However, in a case where the contract had been annuitized i.e. withdrawals were made before the death of the client, taxes may or may not be payable. 
• If the client had opted for a term-annuity, the contract is annuitized to receive a stream of payouts for certain of years. If the client dies before the period has elapsed, the beneficiaries will receive the remaining payments that will be taxed at ordinary income tax rates. 
• On the other hand if the client had opted for variable life annuity, nothing will be received by the beneficiaries in the event of death of the client.
• Tax penalty by IRS/ Federal taxesIt must be noted that when the client makes withdrawals from the variable annuity before attaining the age of 59.5 years, 10% tax penalty is levied by the IRS.
• However, there are following exemptions.Withdrawals are made in case of event of total and permanent disability of the client.Withdrawals are done on or after the death of the client.Withdrawals made from the qualified retirement plan after the retirement from the services and in or after the year the client attains the age of 55 years.
iii. Other implications
The income generated from the investment in the in variable annuity may be partly or fully subject to tax. Full income is subject to tax in the following cases.
• The client did not contribute any funds towards the investment in the variable annuity. 
• The client is not considered to have contributed any funds towards the investment in the variable annuity.
• The client receives all the investment in the contract tax free in the prior years.
• A part of income is subject to tax in the following cases 
• If the client had contributed post-tax funds towards the investment in the variable annuity. The income generated from such a part of funds is not subject to tax.
Thus, these are the basics about the taxes imposed on the income generated from the investment in a variable annuity that investors must know about before investing the hard-earned money. This ensures that the investors’ money is put into a right type of investment where it will work towards providing a safe and secure future and financial independence.
Disclaimer- Information presented on 'Everything that matters' Blog is intended for informational purposes only and should not be mistaken for financial advice. While all attempts are made to present accurate information, it may not be appropriate for your specific circumstances.

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