An annuity is an excellent tool for building financial wealth and adding a steady income stream in retirement. While this can be an excellent investment for some, you must be careful because some have high fees and rules that can be confusing.
The good news is that if you have an annuity that no longer meets your needs, you have the option to sell it, but you will have to pay taxes on the proceeds if you choose this route. Taxes are estimated on the annuity cost basis, but what does cost basis mean in annuities?
Calculation of Annuity Payments
When you purchase an annuity, you can either choose to have your payments dispersed to you as a lump sum or as payments spread over time. The method you choose will determine the amount of your payments, as will the terms and conditions of the annuity.
The payments are based on the principal and rate of return. How much does a $100,000 annuity pay per month? This calculator allows you to put in your annuity information and calculate your payments.
Understanding Annuity Cost Basis
Annuities grow your future income on a tax-deferred basis. Sometimes, you might decide you need the money you are putting into an annuity immediately. When you sell an annuity, you can recover any money after taxes are paid, which is called your annuity cost basis.
In the world of investments, your cost basis is the amount you paid. For an annuity, it is calculated using after-tax dollars. You will not be in double tax jeopardy because the IRS will not tax you a second time on the money when you take it back out because you have already paid taxes on it once. When you sell an annuity, you subtract your cost basis from the proceeds of the sale.
Any payments you have made or money you have withdrawn will affect the final cost basis amount. Money that you put into the annuity will add to your cost basis. Any money that you took out will be subtracted from the cost basis.
One thing that you need to consider is that money is withdrawn based on the last-in, first-out rule. This means that withdrawals impact any growth you might have accumulated before they affect the principal.
Post-TEFRA Cost Basis
The 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) is a piece of legislation designed to help balance the budget. A non-qualified annuity is purchased with after-tax dollars, and a qualified annuity is purchased with pre-tax dollars. When you withdraw from an annuity, only your earnings are taxed on a non-qualified annuity, but all of your payments are taxed on a qualified annuity.
If you take a premature distribution, you will pay a penalty of 10 percent of the taxable amount, with the exception of pre-TEFRA contributions on non-qualified money. Understanding your tax liability will help you to calculate your post-TEFRA cost basis.
Taxes and Selling Annuities
Do I have to pay taxes on a cost basis? The answer to this question can be yes or no depending on the type of annuity and whether you had any pre-TEFRA payments. You also need to consider that you will pay a 10 percent penalty any time you transfer the annuity to another individual, which could affect the post-TEFRA cost basis and the amount you receive.
By now, all of these penalties might have you asking: how can I avoid paying taxes on annuities? The answer is that you can’t. You can choose to pay now or pay later, but at some point, you will have to pay the IRS what you owe.
- To calculate your gain or loss on the sale of annuity, deduct your cost basis from the price at which you sell the annuity. For example, if you sell the annuity for $4,000 and have a cost basis of $5,100, then your loss would be $1,100.
- If you inherited rather than purchased the annuity, your cost basis would be equal to the value of the annuity at the date its previous owner died.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.