Ogghy

Fact checked by Suzanne Kvilhaug

An annuity is a financial product designed to provide a steady income stream during retirement. It is a contract between you and an insurance company, where you make a lump-sum payment or a series of payments. In return, the insurance company provides you with regular income for a set period, typically for the rest of your life.

The Internal Revenue Service (IRS) considers annuities tax-deferred investments because they allow you to postpone paying taxes on your investment earnings until you withdraw or receive payments. This means you won’t have to pay taxes on the interest, dividends, or capital gains your annuity earns until you start withdrawing money. When you start receiving payments, you will owe income taxes on previously untaxed withdrawals at your ordinary income tax rate for the year you receive the payments.

Key Takeaways

• Withdrawals from annuities may be subject to taxes and early withdrawal penalties.
• Reporting annuity income correctly on tax returns is important.
• There are tax planning strategies that can help minimize taxes on annuities.

Taxation of Annuity Payments

According to the IRS, the general rule for taxation of annuity payments says: “The amount of each payment that is more than the part that represents your net cost is taxable.” No matter how your annuity is constructed, you typically owe taxes on the part of any payments you receive on which taxes were not originally paid.

The taxable part represents earnings and any tax-deferred contributions you make. Therefore, the portion that represents a return of principal is not taxed unless it was placed in the annuity on a pre-tax basis. The tax rate that applies to annuity payments depends on your tax bracket.

The tax-deferred growth offered by annuities can be especially beneficial if you are in a higher tax bracket during your working years and expect to be in a lower tax bracket during retirement. By deferring the taxes until retirement, you may be able to pay a lower overall tax rate on the earnings from your annuity.

Warning

If you withdraw money before the age of 59 1/2, you may be subject to a 10% penalty tax in addition to regular income taxes.

Reporting Annuity Income on Tax Returns

To report annuity income on your tax return, you first need to determine the taxable portion of that income. The insurance company that provides the annuity will send you a Form 1099-R showing the total amount of annuity income you received during the year and the taxable portion of that income. You should use the information provided on this form to complete your tax return.

To report this income, fill out Form 1040 or Form 1040-SR and any taxable portion of your annuity income on Form 1040 or Form 1040-SR, Schedule 1.

If you made after-tax contributions to the annuity, you may be able to exclude that portion of your annuity income from your taxable income. However, this exclusion is limited, and you will need to use Form 1040 or Form 1040-SR, Schedule 1, to calculate the amount that can be excluded.

If you are 65 or older or retired due to disability, you may be eligible for the Credit for the Elderly or the Disabled, which can reduce the tax you owe.

It is important to note that reporting annuity income on your tax return can be complex, and it may be helpful to consult with a tax professional to ensure you are reporting your annuity income accurately and taking advantage of any applicable deductions and credits.

Tax Planning Strategies for Annuities

Annuities offer several tax advantages that make them an attractive option for retirement planning.

• Contributions to a qualified annuity are made with pre-tax dollars, meaning the money invested in an annuity grows tax-deferred until withdrawal.
• Annuities have no contribution limits, so you can invest as much as you want, which can be particularly advantageous for high-income earners who have already maxed out their other retirement accounts.
• Annuity payouts are taxed as ordinary income, which can be beneficial if your tax bracket is lower in retirement than during your working years.
• Annuities allow for tax-free transfers between accounts, which can help you manage your tax liability and maximize your retirement savings.

In addition to these advantages, there are a few strategies to minimize the taxes you will pay.

• Transfer or convert deferred annuities into income annuities, which can reduce your tax liability.
• Take withdrawals from non-qualified annuities before taking them from qualified annuities since non-qualified annuities are funded with after-tax dollars, and only the interest or earnings are taxed as ordinary income.
• Take advantage of the tax-deferred growth annuities offer. This allows your investment to compound without being taxed until you receive distributions.

What’s the Difference Between Qualified and Non-Qualified Annuities?

Qualified annuities are funded with pre-tax dollars and are typically held in a tax-advantaged retirement account, such as an IRA or 401(k). Contributions to qualified annuities are tax-deductible, but withdrawals are taxed as ordinary income.

Non-Qualified annuities, on the other hand, are funded with after-tax dollars and are typically held outside of a retirement account. The contributions made to non-qualified annuities are not tax-deductible.

How Are Inherited Annuities Taxed?

Inherited annuities are generally subject to taxation, and the amount and timing of the taxes depend on a few factors, such as whether the annuity is qualified (funded with pre-tax dollars) or non-qualified (funded with after-tax dollars).

Another factor is whether the original owner had begun receiving payments from the annuity before passing away. If the original owner had started receiving payments, the beneficiary may be required to pay taxes on the remaining payments based on their tax bracket. Suppose the original owner had not started receiving payments. In that case, the beneficiary may have the option to either receive a lump sum payment or payments over a set period, which can affect the tax liability.

If you are the beneficiary of an inherited annuity, consult a trusted financial advisor or tax professional to determine the best strategy for minimizing taxes on your inheritance.

What Is the Exclusion Ratio?

The exclusion ratio is a tax term used to describe the portion of an annuity payment that is considered a return of the original investment and, therefore, not subject to taxation. It is calculated by dividing the investment in the contract (the amount of after-tax money invested) by the expected return. The resulting percentage is the portion of each payment that is excluded from taxation as a return of principal.

How Are Roth IRA Annuities Treated for Tax Purposes?

Generally, Roth IRA annuities are tax-free if you follow the rules. The money you contribute to your Roth IRA has already been taxed, so it’s not subject to taxes again when you take it out. If you’re over 59 1/2 and your Roth IRA account has been open for at least five years, any earnings on your contributions can also be withdrawn tax-free. However, there are some exceptions and special rules to be aware of, so it’s always a good idea to consult a tax professional for personalized advice.

What Is Publication 575?

Publication 575 is a document published by the Internal Revenue Service (IRS) that provides information about the tax treatment of pension and annuity income. It explains how to report these types of income on your tax return and includes examples to help you understand the rules. The publication also covers other topics related to pensions and annuities, such as determining the tax-free portion of your distribution and reporting lump-sum distributions.

The Bottom Line

Annuities are tax-deferred investments, meaning you won’t have to pay taxes on the interest, dividends, or capital gains your annuity earns until you start withdrawing money. However, when you start receiving payments, you will owe income taxes on previously untaxed withdrawals at your ordinary income tax rate for the year you receive the payments.

Additionally, if you withdraw money before the age of 59 1/2, you may be subject to a 10% penalty tax. It’s important to consult with a financial advisor or tax professional to understand how annuities fit into your financial plan and what tax implications may apply to your situation.

Reviewed by Robert C. Kelly
Fact checked by Michael Rosenston

Tier 1 and Tier 2 are two types of capital banks hold. Tier 1 capital is a bank’s core capital, which it uses daily. Tier 2 capital is a bank’s supplementary capital, which is held in reserve. Banks must hold certain percentages of capital on hand to help ensure the stability of the financial system. A bank’s total capital is the sum of Tier 1 and Tier 2 capital.

Key Takeaways

• Bank regulations require that Tier 1 and Tier 2 assets must be at least 10.5% of their risk-weighted assets.
• Tier 1 capital is the primary funding source of the bank and consists of shareholders’ equity and retained earnings. 
• Tier 2 capital includes revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves.

Bank Regulations

Under the Basel Accords, a bank must maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. The Basel Accords are three sets of banking regulations that help to ensure financial institutions have enough capital on hand to handle obligations.

The Accords set the capital adequacy ratio (CAR) to define these holdings for banks. Under Basel III, a bank’s Tier 1 and Tier 2 assets must be at least 10.5% of its risk-weighted assets. Basel III increased the requirements from 8% under Basel II.

Note

The Basel Accords are international banking regulations that ensure banks have enough capital on hand both to meet their obligations and absorb any unexpected losses. They are set by the Basel Committee on Banking Supervision (BCBS).

Tier 1 Capital

Tier 1 capital consists of shareholders’ equity and retained earnings. It is a bank’s core capital and includes disclosed reserves on the bank’s financial statements. This money is used daily and is a primary indicator used to measure a bank’s financial health.

Tier 1 holds nearly all of the bank’s accumulated funds. Under Basel III, the minimum tier 1 capital ratio is 6%, which is calculated by dividing the bank’s tier 1 capital by its total risk-weighted assets (RWA). Additionally, the total capital must be at least 10.5%. RWA measures a bank’s exposure to credit risk from the loans it underwrites.

Assume a financial institution has US$200 billion in total tier 1 assets. If they have a risk-weighted asset value of $1.2 trillion, the capital ratio is 16.66%:

($200 billion / $1.2 trillion)*100=16.66%

This is well above the Basel III requirements.

Tier 2 Capital

Tier 2 capital is a bank’s supplementary capital and includes undisclosed funds that do not appear on a bank’s financial statements, revaluation reserves, hybrid capital instruments, junior debt securities, and general loan-loss or uncollected reserves.

Revalued reserves recalculate the current value of a holding that is higher than what it was originally recorded as, such as with real estate. Hybrid capital instruments are securities that have equity and debt qualities, such as convertible bonds. Tier 2 capital is less reliable than Tier 1 capital and more difficult to liquidate.

Under Basel III, the minimum total capital ratio is 10.5%, and a minimum of 6% must be Tier 1 capital. Therefore, 4.5% can be Tier 2 capital if a bank has exactly 10.5% total capital. If the bank from the example above reported Tier 2 capital of $30 billion, its Tier 2 capital ratio for the quarter would be 2.5%:

($30 billion/$1.2 trillion)*100 = 2.5%

Thus, its total capital ratio was 19.16% (16.66% + 2.5%). Under Basel III, the bank met the minimum total capital ratio of 10.5%.

What Does It Mean That Tier 2 Capital Is “Gone Concern?”

Tier 2 capital is a type of gone-concern capital. If a bank fails, its Tier 2 assets will absorb any losses before its creditors or depositors do.

What Does a High Tier 1 Capital Ratio Mean?

A bank’s tier 1 capital ratio compares its core equity assets to its risk-weighted assets. A high ratio means that the bank has enough liquid assets on hand and is more likely to absorb losses without the risk of a bank failure.

What Was Tier 3 Capital?

Previously, the tiers of capital included a third layer. Tier 3 capital is tertiary capital, which many banks hold to support their market risk, commodities risk, and foreign currency risk, derived from trading activities. Tier 3 capital was abolished under the Basel III accords.

The Bottom Line

Tier 1 capital is the primary funding source of a bank. It consists of shareholders’ equity and retained earnings. Tier 2 capital is less liquid and includes assets such as revaluation reserves, hybrid capital instruments, and undisclosed reserves. Banking regulations known as the Basel Accords require banks to hold a specific percentage of assets.