In the comment section of my recent post about using deferred annuities to reduce risk and increase income in retirement one of my readers asked a great question:

How are they taxed? Is there risk that your annuity company goes under?

Reader “CB24”

These are both great questions that I should have answered in my original post.

How are annuities taxed?

The answer depends on how you bought the annuity.

If you bought the annuity using “pre-tax” money (i.e. you bought the annuity inside a 401k, IRA, or similar retirement account) then any income from the annuity will be taxed as regular income.

If you bought the annuity using “after tax” money then you pay income taxes on the earnings portion of each payment. The IRS considers part of each payment to be a return of your principle and part of each payment to be taxable gain. 

Let’s look at an example. Let’s say you’re 65 and you spend $100,000 to buy a deferred annuity that will pay $50,000/year starting at age 85. To determine what percentage of your income is considered taxable gain and what percentage is considered return of principle we first need to consult the IRS actuarial tables. Here’s the table from IRS Publication 590-B

In the table we see that an 85 year old is expected to live for 7.6 additional years.

This means the total expected annuity payout is 7.6 years * $50,000/year = $380,000. The IRS expects the average 85 year old person to get $380,000 in total payments before they die.

The annuity was purchase for $100,000, which means that $100,000/$380,000 = 26.3% of each payment is considered a return of principle and therefor not taxable. The remaining 73.7% of each payment is investment return and taxable.

That means that for our $50,000 annual benefit, $36,850 (73.7% of $50,000) is taxed as regular income.

This continues until the expected lifespan is reached (in this case, after 7.6 years). At that point, the IRS considers all of your principal to have been returned, so 100% of all future payments will be taxed as regular income.

One important distinction here – this is not “earned income”, which means that you’ll pay state and federal income taxes but not FICA, unemployment, etc.

What if your annuity provider goes under?

This is a critical question. After all, a deferred annuity is an agreement where you are giving a company money today and then relying on receiving money back at some point in the (possibly distant) future.

For example, you might, at 45 years old, decide to purchase a deferred annuity that will start paying at age 75. That means 30 years will pass between when you give the company money and when you expect to start receiving your annuity payments.

There are a few ways to address this risk.

Insurance regulation

First, remember that annuities are insurance contracts, not investments. This means they are sold by insurance companies and regulated by your state insurance commissioner. They are required to maintain minimum capital requirements, provide yearly reports on their financial strength and reserves, etc.

In addition, each state has an insurance guaranty association. You can think of the state insurance guaranty associations as the insurance equivalent of FDIC insurance (which protects against bank failures). Every insurance company pays into this fund for every policy they offer. If your insurance company goes bust, the state fund will step in to pay your benefits, up to an amount set by the state. Most states follow the  National Association of Insurance Commissioners’ (NAIC) Life and Health Insurance Guaranty Association Model Law, which  provides coverage of up to $250,000 in annuity benefits. The coverage for your state can be found here. 

In most states, the individual coverage limit is doled out on a per-company basis, so if you have two policies with two different companies, you will get double the coverage.

Read more: Are You Protected If Your Insurance Company Goes Belly-Up? https://www.investopedia.com/articles/insurance/09/insurance-company-guarantee-fund.asp#ixzz5UKN5x8yu 
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If your annuity has benefits that would exceed this amount then you’d essentially be a creditor during the bankruptcy proceedings for the company.

Insurance company financial strength ratings

It’s nice to know that you’d receive some benefits, even in the event that your annuity provider goes out of business, but it’s obviously better to pick a financially sound company that’s unlikely to go bankrupt in the first place.

The good news is that a number of companies investigate and report on the financial strength of insurance companies. These are mostly the same companies that provide bond ratings – Standard & Poor’s (S&P), A.M. Best, Moody’s, and Fitch. The ratings are the same as for bonds. For S&P the highest rating is AAA. The next is AA+, then AA, then AA-, etc.

How much do these ratings matter? Well, here’s some data from S&P that links financial rating to the failure rate of insurance companies.

This data shows that a company rated AA or higher has less than a 1% chance of failure over the next 10 years.

Reducing the risk of failure

By putting the two previous sections together we get a clear solution. To minimize the impact of a potential insurance company failure, you should:

  • Spread your annuity contracts out across multiple insurance companies
  • Keep each annuity contract to less than the maximum coverage limit of your state’s insurance guaranty association
  • Only do business with insurance companies with a financial strength of at least A (or the equivalent rating from other ratings companies).

Conclusion

I hope that answers your questions about how annuities are taxed and how to minimize the potential impact of the failure of an insurance company.