Taxation benefits of lifetime annuities

Lifetime annuities can provide significant benefits for retirees. For some, the concessional social security means test assessment can improve their Age Pension outcomes. For others, the benefit of income certainty for life helps them manage longevity risk in retirement.

Information on the technicalities of Challenger’s lifetime annuity including its social security treatment can be found in Challenger’s lifetime annuities technical guide on AdviserOnline. 

An investment into a lifetime annuity can also help diversify the defensive component of a retiree’s investment portfolio and help provide tax effective retirement income. 

This month’s article discusses in detail how a lifetime annuity’s regular payments and lump sum death benefits are taxed. 

Lifetime annuities referred to in this article are for Challenger’s Lifetime Annuity (Liquid Lifetime) – Flexible Income option. 

Tax treatment of superannuation sourced lifetime annuities 

A Challenger lifetime annuity can generally only be commenced with superannuation money for investors age 60 and over. For these investors, the regular payments are tax free. Any lump sum death benefit payable is subject to superannuation death benefit tax rules – tax-free if paid to a tax dependent and up to 15% tax on the taxable component (element taxed) if paid to a non-tax dependent, plus Medicare Levy (where applicable). 

For transfer balance cap considerations, the purchase price of a superannuation lifetime annuity will be a credit towards the investor’s personal transfer balance account and a lump sum commutation will be a debit. 

Tax treatment of non-superannuation sourced lifetime annuities 

Unlike other non-superannuation investments, the regular payments from a non-superannuation sourced lifetime annuity are afforded a deductible amount. Only the portion of the annuity’s regular payments that are above the deductible amount are subject to tax. The deductible amount also plays a role in determining whether a lump sum death benefit is subject to tax for the beneficiaries or estate.

Tax treatment of a lifetime annuity’s regular payment 

The tax treatment of a lifetime annuity’s regular payment is as follows: 

Assessable income for tax purposes = Regular payment less deductible amount 

The deductible amount is the part of each regular payment that broadly represents the return of the original investment capital. This amount is tax free. 

The deductible amount is calculated as follows: 

Deductible amount = Purchase price / Investor’s life expectancy at commencement 

For lifetime annuities commenced from 1 January 2020 the Australian Life Tables 2015-2017 is used to determine life expectancy. For policies with a reversionary beneficiary, the longest life expectancy of the investor and beneficiary is used to calculate the deductible amount. 

The deductible amount does not change and continues for the life of the policy even if the investor lives past their life expectancy. Where the regular payment from the annuity is less than the deductible amount, there is no assessable income for tax purposes. The excess deductible amount does not reduce other assessable income of the individual. 

The excess deductible amount is carried forward and may be used to offset assessable income from the same lifetime annuity in future years (if any). This can occur where payments have been indexed over time.

Example: Melissa using a lifetime annuity to provide tax-effective retirement income 

Melissa (age 75) is a single homeowner who has recently sold her investment property for $1 million to continue to fund the retirement lifestyle she desires. She has been spending $60,000 p.a. over the last few years and expects this to continue into the foreseeable future. 

She now has $1.1 million invested in a range of cash and term deposit investments (which are currently earning 4% p.a.) and does not see a need or have a desire to invest in growth assets. 

As an alternative to her cash and term deposit investments, Melissa can consider investing a portion of her portfolio into another defensive asset – a lifetime annuity – which can provide her with more tax effective income. 

Based on a Challenger quote as at 24 October 2023, an investment of $220,000 (20%) into a lifetime annuity provides Melissa with regular payments of $15,436 p.a. indexed to CPI or $19,268 p.a. without any indexation. 

The deductible amount for Melissa’s lifetime annuity will be $220,000 / 14.15 = $15,548 p.a.

Table 1 below compares Melissa’s year 1 income and tax position for the following scenarios:  

1. $1.1 million invested in term deposits earning 4% p.a.
2. $880,000 invested in term deposits earning 4% p.a. and $220,000 (20% of her portfolio) invested in a Challenger lifetime annuity with regular payments not indexed.
3. $880,000 invested in term deposits earning 4% p.a. and $220,000 (20% of her portfolio) invested in a Challenger lifetime annuity with regular payments indexed to CPI.

Table 1: Year 1 cash flow and tax comparison for Melissa

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