Fixed index annuities, also known as equity-indexed annuities are considered a hybrid between a fixed annuity and variable annuity. The fixed index annuity is indexed to a popular index – typically the S&P 500. Although this type of annuity is regulated by the Securities and Exchange Commission, its tax implications are similar to those governing fixed, non-qualified annuities in general. The main features are tax deferral and mandatory distributions.
• Tax deferral
One of the primary tax features of fixed index annuities is tax-deferred treatment. Such annuities are funded by after-tax dollars, making this feature possible. Tax deferral implies that accumulated earnings on FIAs are tax-exempt in the contribution phase. Instead, only the earnings portion of a fixed index annuity distribution is taxable after maturity.
• Tax-exempt lump sum at maturity
When fixed annuities mature, part of the accumulated fund is distributed tax-free and the rest is committed to annuitization. The tax free lump sum can be viewed as a partial return of contributions to the annuity investor.
• Premature distribution penalty
Equity indexed annuities have a mandatory distribution window – between 59 ½ years and 70 ½. Early distributions incur a 10% tax penalty on the taxable amount. Some fixed index annuities allow for penalty-free withdrawals of contributions, but this aspect is determined by the particular contract with the annuity provider.
• Aggregation rule
For tax purposes, annuity contracts issued by the same insurer/annuity provider to the same policyholder are treated as one annuity contract. This rule is called the aggregation rule.
• Mandatory distributions
FIAs have mandatory distribution periods before and after maturity. Before maturity, distribution is mandatory upon the death of the annuity owner. If this happens, the beneficiary can choose among the following options: lump sum, complete withdrawal within five years of death or annuitization. If the owner dies after annuitization has occurred, the distributions can stop, or form part of non-taxable income from the annuitant’s estate. The mandatory window (between ages 59 ½ and 70 ½) gives annuitants less flexibility in deferring payments or bequeathing the annuity fund entirely to beneficiaries. Such features are offered by Roth IRAs.
That the FIA is a deferred annuity governs all of its tax implications. Tax deferral is not merely a tax benefit, but it allows better accumulation as well. This is because taxation in the accumulation phase handicaps fund growth. Fixed index annuities remain somewhat controversial, but there are a few tax benefits to go along with other merits of this hybrid annuity.