Dear Tax Talk, I believe the interest portion of an immediate annuity distribution is taxed as ordinary income and the principal portion is tax-free. The entire distribution (after age 59 1/2) from a traditional individual retirement account is taxed as ordinary income. May I use the balance of a savings incentive match plan for employees, or SIMPLE, IRA (for example, $200,000) to acquire an immediate single premium annuity by rolling the IRA into the annuity and thus avoid ordinary income tax treatment on the IRA distribution and pay only ordinary income tax on the interest portion of the annuity distributions? -- Barton
Continue Reading Below
Dear Barton, You have the taxation of an annuity correct. What you're missing is how the annuity was acquired. Buying an annuity with after-tax dollars versus pretax dollars in an IRA changes the taxation of the principal return.
An annuity is a contract you purchase usually from an insurance company that will provide you with periodic payments. Those payments consist of an interest element and principal return, which is the amount that was paid for the annuity. Think of it as a reverse loan: You lent the insurer money, and they are paying you back periodically.
An immediate annuity means that you start to receive the payments immediately after purchasing the contract. In a deferred annuity, the amount paid continues to be invested by the insurer until such time as you choose to receive payments.
An IRA can be invested in an annuity contract. In fact, an IRA is similar to an annuity in that the owner of the IRA can take periodic payments from the IRA. This is kind of the concept of the required minimum distribution.
Although you can roll an IRA into an annuity contract, the source of the capital invested in the contract is still pretax dollars. Hence, the payment of the principal to you will always be taxable.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.