Misunderstanding the tax on annuity income
By John L. Olsen, CLU, ChFC, AEP
Olsen & Marrion, LLC
Every so often, someone asserts that the tax on annuity income isn't really taxed at the marginal rate for ordinary income, that's it's really taxed at the taxpayer's "blended" or "effective" rate, which is tax paid/total income.
Recently, an article appeared on another web site in which the author advised agents, "You can easily show clients the beauty of the progressive tax system, that the payments are often taxed at a much lower effective tax rates rather than the perceived marginal tax rate."
I responded as follows:
If Joe Consumer, who already has earned income and income from investments, is considering investing $X in either a deferred annuity or an alternative investment, the return on those investments, whenever realized, will be taxed at the marginal rate — the rate for the last dollars of his income. The notion that one ought to look at the blended rate and apply that rate to the annuity income is simply incorrect. Don't take my word for it. It's easy to check.
First, compute Joe's tax as if he'd never bought the annuity or alternative. Call the result A. Then compute it, including that excluded value. Call that result B. Subtract A from B. Then divide that remainder by the dollar value of the income from that investment (the value excluded or included, above). That's the tax on those dollars. It's not a blended rate; the blended rate applies to Joe's total income, and is just as allocatable to his earned income and income below the standard deduction as to the annuity/alternative earnings.
Moreover, if the annuity in question is a variable deferred annuity and the alternative is stocks or stock mutual funds/ETFs, the income from those two alternatives will be taxed largely — or even entirely — under two entirely different tax regimes. The stocks/stock fund returns will be, to the extent that they represent capital gains from positions held for over one year, taxed at the taxpayer's long-term capital gains rate. The annuity income, to the extent that it's possible to include it in taxable income, will be taxed as ordinary income.
There are lots of reasons why a deferred annuity — either variable or fixed — might be suitable, appropriate and a good choice for a consumer in many different fact situations. We don't need to invent reasons that are simply untrue. (I'm not suggesting that anyone deliberately use the argument I describe above, knowing it to be false.) I've heard colleagues repeat it to me who clearly believed it to be true. But it ain't. Insisting that Joe's annuity income is taxed at Joe's effective/blended rate is just as wrong as telling him that the first dollar of his income (before he has earned even his personal exemption amount) is taxed at that rate.