September 12, 2004

Along with the rewards of an income stream for life, a lifetime fixed immediate annuity carries the penalty of taxation until death. Some account holders pay quarterly or yearly taxes on every penny they receive from an annuity. Others pay taxes on just a portion of each payment.

How payments from lifetime fixed immediate annuities are taxed depends on a number of factors, such as the age of the annuitant, the size of the original investment in the annuity and the means by which the account was funded.

LetM-Fs review two common cases: a lifetime fixed immediate annuity funded with pretax dollars from a 401(k) or other employer-sponsored retirement plan, and an identical annuity funded with after-tax dollars, such as savings in a taxable account.

Figuring out the taxes for 401(k)- funded annuities is quite simple. Because no income taxes were paid on money that originally went into the account, everything that comes out of it is taxed as ordinary income.

If, for example, you receive $9,000 a year from an annuity funded with pretax dollars, that $9,000 is taxed as ordinary income, said Jim Magner, a tax attorney and head of the advanced- annuity sales department at Lincoln National Corp.

With lifetime fixed immediate annuities funded by savings outside a retirement account, taxation becomes a more difficult proposition. Part of the payment is taxed as income and part is treated as a M-treturn of premiumM-v and not taxed. It boils down to a two-step arithmetic equation, said Michael Berry, a certified financial planner and senior marketing consultant with ING GroupM-Fs advanced- annuity sales. (For further details, see IRS Publication 939: General Rule for Pensions and Annuities.)

You first multiply the monthly payout (say $750) by the number of annual payments (12) by the number of years that person is expected to live (say 15 years). That comes to $135,000 in total payments.

Then divide the value of the original investment (say $100,000) by the product in Step 1. The $100,000 (the original investment) divided by expected lifetime payments ($135,000) gives you a so-called M-texclusion ratioM-v of 74 percent.

M-tThe exclusion ratio determines which portion of the payment (74 percent in our hypothetical case) is return of premium,M-v Berry said.

On a $9,000 annual payment, therefore, $6,660 would be treated as a return of premium, and $2,340 would be taxed as ordinary income. M-y Matthew Lubanko