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How Are Annuities Taxed?

ivon t hughes

December 10, 2013

 

by

Ivon T Hughes

 

 

Disclaimer

The information in this section reflects our understanding of current federal and provincial income tax laws. Annuity taxation laws are subject to change; rules and restrictions may differ in the future. It’s important to seek advice from a tax consultant regarding the tax implications for your individual situation.

 

How Are Annuities Taxed?

 

Taxation Summary

Registered Annuities – Income from an annuity purchased with registered funds is fully taxable to the policyholder in the year it’s received.

 

Non-registered Annuities – Income from an annuity purchased with non-registered funds can have prescribed, non-prescribed (accrual) or level tax treatment.

 

Withholding Tax – Canadian witholding tax is mandatory for annuities purchased with RPP (locked-in and non locked-in), LIF or DPSP premiums. If you are a non-resident the applicable rate of withholding tax will be deducted for any annuity that has been purchased.

 

 

Introduction to Annuity Taxation

Registered vs Non-registered Taxation

Prescribed Taxation

Non-prescribed (accrual) Taxation

Level Taxation

Taxation During the Deferral Period

Withholding Tax

Mandatory Withholding Tax

Optional Withholding Tax

Taxation of Non-Residents

Income Splitting

Pension Income Tax Credit

Avoiding OAS Clawback

Potential Creditor Protection

 

Registered vs. Non-Registered Taxation

Income from an annuity purchased with registered funds is fully taxable to the policyholder in the year it is received. Income from an annuity purchased with non-registered funds can have one of three different tax treatments – prescribed, accrual or level.

 

Prescribed Taxation

During the payout period, prescribed annuity payments are considered to be a level blend of interest and capital. That is, a fixed portion of each annuity payment will be taxable.

 

An annuity contract must qualify for prescribed tax treatment . To qualify as a prescribed annuity, the contract must satisfy the following conditions:

The policyholder(s) must also be the annuitant(s). The policyholder can be a testamentary or spousal trust .

 

A joint life annuity is permitted if the second annuitant is either:

- a brother or sister of the first annuitant (policyholder)

- a spouse of the first annuitant

 

The annuity must be non-commutable.

Annuity payments must start by December 31 of the year following the purchase date .

 

Annuity payments must be equal, not indexed, and made regularly and at least annually .

 

Payments may reduce on the first death under a joint life annuity .

 

Annuity payments can be for:

- a fixed term

- life of the annuitant(s)

 

For a guaranteed or fixed term, the term cannot extend beyond the annuitant’s 91st birthday. For joint life annuities, the age of the youngest annuitant can be used.

 

Prescribed taxation applies automatically if the above conditions are met. The policyholder can request accrual taxation but must inform us in writing before the end of the year in which payments begin.

 

A policy could change tax treatment during a year if one or more of the qualifying conditions changes. For example, when an annuity with an income start date deferred beyond December 31 of the year following purchase begins payments, the tax treatment would change from accrual to prescribed.

 

Non-Prescribed (accrual) Taxation

In contrast to a prescribed annuity, income from a non-prescribed annuity – also known as an accrual annuity – is taxed on interest earned in the policy from the purchase date to the policy anniversary, and then annually on each policy anniversary.

 

Generally speaking, non-prescribed annuities have larger taxable amounts in the early years than similar prescribed annuities. These amounts decrease each year . Under a non-prescribed annuity, a policyholder in the early years of the policy may be required to include in taxable income an amount greater than the annuity income received in a given year.

 

Level Taxation

Any unreported taxable gain (interest earned) from a life insurance policy issued prior to December 2, 1982, isn’t taxable until the policy is surrendered or annuitized. Upon annuitization, any unreported taxable gain will be spread over the expected number of annuity payments.

 

Taxation During the Deferral Period

Registered

- Registered annuities are non-taxable during the deferral period .

 

Non-registered

- All annuities are taxed on an annual basis and receive accrual tax treatment . Once income payments begin, and assuming all conditions are met, the tax treatment will change to prescribed* . The tax treatment remains accrual if the conditions are not met or the client requests that the tax treatment remain accrual. * For an annuity with prescribed taxation if income is deferred more than one year from purchase, tax treatment will be accrual until payments start.

 

Withholding Tax

Tax is withheld at source and remitted to the Canada Revenue Agency (CRA). The payment a client receives is net of withholding tax . Note: Illustrations and policy pages show gross income, not net income.

 

Mandatory Withholding Tax

We must withhold tax if the policyholder purchased the annuity with locked-in registered pension plan (RPP), non locked-in RPP, LIF or deferred profit sharing plan (DPSP) funds . We base the tax withheld on formulae supplied by CRA . It incorporates various personal tax credits, including basic personal, disability and pension income.

 

Optional Withholding Tax

We can withhold additional tax at the client’s request . A policyholder can ask us to withhold their entire periodic payment amount.

 

If the annuity is:

 

Registered and non-registered (prescribed or level taxation) – We can withhold any amount of optional tax . The request must come from the policyholder and the amount should be stated as a percentage.

 

Non-registered (accrual taxation) – We cannot withhold tax.

 

Taxation of Non-Residents

When the policyholder of a payout annuity becomes a non-resident, we base their tax on the source of funds used to purchase the annuity and the policyholder’s country of residence.

 

Canada imposes a withholding tax of 25 per cent on payments made to a non-resident of Canada. This rate may be altered by a treaty between Canada and the country of residence.

 

An individual may apply to CRA to have the amount of statutory withholding tax reduced . If CRA approves the request, they will notify the institution of the proper tax deduction.

 

For a deferred annuity, no tax form is issued during the deferred period . Once payments begin, Canada imposes a withholding tax.

 

Income Splitting

Income from a payout annuity may qualify for income splitting for income tax purposes . This would allow the policyholder to transfer to their spouse up to 50 per cent of the taxable income earned from the payout annuity . The income splitting is done by the policyholder on their annual tax return . We will issue a tax slip to the policyholder for the full taxable amount.

 

Pension Income Tax Credit

Income from a payout annuity may qualify for the federal pension income tax credit . This credit can be claimed in the non- refundable tax credit portion of a client’s tax return if the taxpayer has eligible pension income . The maximum credit is $2,000.

 

Eligible Pension Income

For individuals age 65 and over, amounts reported in:

- Box 19 of a T5 – Accrued Income

- Box 16 of a T4RSP

- Box 024 of a T4A – payments from a life annuity sourced by pension funds

 

For individuals under the age of 65 - payments from a life annuity sourced by pension funds – Box 16 of a T4A f or i ndividuals of any age - payments from an annuity purchased with death proceeds, regardless of the taxpayer’s age.

 

Avoiding OAS Clawback

If a taxpayer’s taxable income is too high, some government benefits may be reduced or not available. Or, the taxpayer may not qualify for some income-tested tax credits.

 

Investment income is included in taxable income at different rates . For example, interest income is included on a tax return at 100 per cent, and dividend income is “grossed up” before it’s included in income . For income from a prescribed annuity (non-registered), only a portion of a payment is taxable and the taxable portion is the same every year.

 

A client may be able to restructure their investment portfolio to reduce their taxable income by using some of their assets to purchase a prescribed payout annuity . The client can maintain a desired level of income but reduce taxable income, which will allow them to avoid the clawback or disqualification from some benefits or credits.

 

Potential Creditor Protection

If the annuity is purchased with locked-in money, the contract and the income may be protected from creditors based on applicable pension legislation.

 

If the annuity is purchased with non locked-in money, during the guaranteed period, the contract and income may be protected if there is an appropriate family or irrevocable beneficiary designation.

 

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About the Author:

Ivon T Hughes is a leading expert in life annuities in Canada. His website LifeAnnuities.com is a recognized authority on annuities. He's also an established insurance and investment broker, licensed across Canada through The Hughes Trustco Group since 1972. Recently, he's been redefining how annuities are sold in Canada.

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