27. Tax Favored Annuity

The popularity of annuities as investment vehicles is due to two important principles. First, the interest earned on the deposit accumulates income tax free. Second, at retirement your tax bracket may be lower and you may select a life income annuity. The annuity guarantees you an income for the rest of your life and spreads your taxable income over many years.

The rate of return on your annuity will fluctuate with the prevailing market interest rates. Insurance companies may invest the funds in either fixed or variable income funds. You may choose from the funds the
insurance company offers. In many cases the insurance company will guarantee an interest rate for a period of time.

In the event of your death, you may select a beneficiary to receive the funds during the accumulation period or the balance of a guaranteed amount under a payout option.

Before the Tax Equity and Fiscal Responsibility Act of 1982 was passed, an annuity contract holder could withdraw tax free his initial investment for other, more immediate uses. The new law forces an immediate
tax on early withdrawal of investment amounts from deferred annuity contracts. Partial surrenders, withdrawals and distributions in the nature of dividends (if any), prior to the annuity starting date, will be taxed to the extent the cash surrender value exceeds the investment in the contract. What's more, loans (or loan substitutes, such as pledges and assignments) are treated as taxable distributions.

Also, a 5% premature distribution penalty is imposed on early withdrawals. The penalty won't apply to taxable amounts received after age 59-1/2, on account of death or disability, or as one of a series of
substantially equal periodic payments for life (or over a period of at least 60 months following the annuity starting date).

Example: Ed, age 45, decides to buy an annual-premium deferred annuity contract. He can afford to put away $2,000 a year. At present market rates, this will provide an annuity income of $20,000 a year at age
65. Under prior law, if Ed wanted to use the money invested in the contract sooner, he'd be able to withdraw total premiums paid tax free. For example, at the end of Year 10, Ed could take out $20,000 ($2,000
premium x 10 years) for other uses (reducing annuity income at age 65 to approximately $12,000 a year).

Under the new law, however, Ed's withdrawal of part of his investment in the contract triggers an immediate tax. The $20,000 withdrawal in Year 10 is taxed to the extent the cash surrender value ($39,300 under typical
tables) exceeds the investment ($20,000). In other words, only $700 of the $20,000 withdrawal (20,000-19,300) escapes tax. If Ed is in the 50% bracket, the $20,000 withdrawal costs him an extra $9,650 in tax. Unless
one of the exceptions applies, Ed also has a $965 (5% of $19,300) premature distribution penalty to pay.

What about existing contracts? The new rule doesn't apply to contracts entered into before August 14, 1982. However, investments in the contract made after August 13, 1982 are covered.

Tax reference verification 1-800-829-1040

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