Understanding the annuity aggregation rule
Years ago, annuity buyers could utilize a strategy of buying multiple contracts and withdrawing from just one as a way to save on taxes.
This changed in 1988 when Congress closed this loophole with what is known as the annuity aggregation rule.
The basic premise of this rule is that if you own multiple nonqualified annuities (which are contracts outside of a tax-qualified retirement plan such as a 401(k) or IRA), the IRS will treat all of those annuities as a single entity for tax purposes.
It’s important to understand how deferred annuities are taxed. Money deposited in a deferred annuity grows tax-deferred until you take distributions. You will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it. For example, if the value of your annuity doubles what you deposited, then half of your income withdrawals will be taxed as regular income. The other half will be considered a return of your principal.
However, if you take advantage of your insurer’s free withdrawal provision, which allows you to take out a percent of your annuity’s account value without risk of a surrender charge, the IRS typically treats the withdrawal as a withdrawal of interest, regardless of the actual interest income inside the annuity.
Before the aggregation rule, a typical tax-saving strategy could work like this:
An investor could purchase five annuities for $100,000 each. Two years later, all five annuities have account values of $108,000; they have essentially been credited with 8 percent interest during this period.
The annuity holder decided to withdraw $40,000 from just one of the annuities. Because only $8,000 of that amount was considered gain in the contract — the rest was considered the original principal — under previous rules the contract holder was only taxed on $8,000 of the income. The other $32,000 was primarily a tax-free withdraw.
Now with the aggregation rule, the five annuities combined are considered to have earned $40,000 in interest over two years ($8,000 in each of the five contracts). Therefore, the entire $32,000 withdrawal is considered interest income for tax purposes.
The rule applies even if the annuities have generated different amounts of interest growth. For example, say you purchased five annuities for $100,000 each. One earned $2,000 interest in the first contract year; another earned $5,000 in interest and another earned $10,000, while the other two earned nothing. You make a withdraw of $7,000 from one of the annuities that earned nothing. You still must pay tax on the full $7,000 because the aggregated total of interest was $17,000, so the $7,000 withdraw if part of that.
This rule only applies if the contracts are all deferred annuities issued by the same insurance company. It does not apply when contracts are purchased from different insurance companies or if one annuity is deferred and another is immediate.
Another important consideration is that the aggregation rule does not apply when you annuitize one or more of the contracts. Annuitization is the process of turning the contract’s account value into a stream of payments, either for a lifetime or for a specified period.
Another way to avoid the aggregation rule is to have different owners of multiple annuity contracts. For example, a married couple could have one annuity owned by one spouse, another owned by the second spouse and a third owned by a trust. This would allow three policies that would not be affected by the aggregate rule.