The Annuity Taxation Primer for Physicians

By: Gary A. Cook, MSFS, CFP®, CLU, ChFC, RHU, LUTCF, CMP™ (Hon); with Kathy D. Belteau, CFP®, CLU, ChFC, FLMI, and Philip E. Taylor, CLU, ChFC, FLMI 

Introduction  

The tax treatment of annuities is dependent on whether it is a qualified or non-qualified annuity.  Although both permit the tax-deferred growth of the investment and both have penalties for early distributions, they are governed under different sections of the IRC. 

Qualified Annuity Taxation

Qualified annuities are treated no different than any other tax-qualified retirement investment.  Growth of the investment, whether fixed interest or variable-based, escapes current taxation under one of the 400-series IRC sections. 

Additionally, if the funds are withdrawn prior to age 59½, there is a 10 percent penalty.  As the money is withdrawn, every dollar is taxed as ordinary income.  

Finally, fund distributions must begin no later than April 1 of the calendar year following the year when the owner turns age 70½.

Non-Qualified Annuity Taxation 

The taxation of non-qualified annuities is generally contained within IRC § 72.  Again, the annuity is provided tax-deferred growth and the 10 percent penalty for early withdrawal.  The manner that distributions are taken, however, will determine the nature of their taxation.

Withdrawals

Withdrawals from non-qualified annuities are taxed in one of two ways depending upon when the annuity was issued.  Annuities issued prior to 8/14/82 had FIFO accounting (first in, first out). Since principal was first in, it came out first, tax-free.  With annuities issued on 8/14/82 and thereafter, taxation changed to LIFO (last in, first out). Simply put, withdrawals are now taxable since interest is withdrawn first.  

However, if annuitization is chosen, the insurance company using governmental tables develops an exclusion ratio.  This permits a portion of each received payment to be considered a return of principle and thus only a portion of each payment is taxable.  This exclusion ratio remains in effect until the insurance company has returned all of the original principle to the owner.  After that, every payment received will be considered 100 percent earnings and totally subject to ordinary income taxation. 

The 10% Excise Penalty Tax      

Just like an IRA, there is a 10% excise tax penalty on premature withdrawals for deferred annuities.  The government extends tax advantages to the annuity for retirement purposes. The government also extends tax disadvantages to taxpayers who do not use the annuity for retirement. All interest withdrawn prior to the owner being age 59½ will be subject to a 10% excise tax penalty.  

Exceptions to this penalty tax are disability of taxpayer, distribution from a pre 8/14/82 annuity, death of the owner, payout from an immediate annuity or substantially equal payments over the taxpayer’s life expectancy.

Wealth Transfer Issues

Regardless of whether the medical professional or healthcare practitioner has a qualified or non-qualified annuity, extreme care must be given when specifying beneficiaries.  Although these investments have great potential for appreciating sizable amounts of wealth during a lifetime, they are, unfortunately, very poor vehicles for the transfer of this wealth to successor generations after death.

Upon the death of an annuity owner, an annuity can be subject to both federal estate and federal income taxes.  This double taxation often results in a 40 to 70 percent loss of annuity value before the heirs can receive it.   The retired medical professional should seek wealth transfer advice if he/she holds a large portion of their wealth in annuities or other qualified plans such as IRAs. One good strategy to consider may be the Stretch IRA. 

Conclusion

As always, your thoughts and comments on this Executive-Post are appreciated.

Related Information Sources:

Practice Management: http://www.springerpub.com/prod.aspx?prod_id=23759 

Physician Financial Planning: http://www.jbpub.com/catalog/0763745790 

Medical Risk Management: http://www.jbpub.com/catalog/9780763733421

Healthcare Organizations: www.HealthcareFinancials.com 

Health Administration Terms: www.HealthDictionarySeries.com

Physician Advisors: www.CertifiedMedicalPlanner.com

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com  or Bio: www.stpub.com/pubs/authors/MARCINKO.htm

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Filed under: Taxation | Tagged: Insurance Matters |