Changes made to the taxation of prescribed annuity contracts (PACs)1 impacts the proportion of the annuity payment that will be taxable income.
Under legislation introduced by the federal government, PACs issued after 2016 will have to use an updated mortality table to calculate the return of capital portion of each annuity payment. The prescribed table for those annuities will be the Annuity 2000 Basic Mortality Table of the Society of Actuaries (Annuity 2000 Table) instead of the current 1971 Individual Annuity Mortality (IAM) Table. This change will increase the life expectancy of the annuitant, which will decrease the return of capital portion and, potentially, increase the taxable portion of the annual annuity payments from a PAC.
The legislation provides that the 1971 IAM Table will apply to annuities that were issued up to the end of 2016 and that:
- are prescribed annuities; or
- would have been prescribed annuities except that annuity payments have not commenced and for which the annuity rates are fixed and determined before 2017 and cannot be terminated except by the death of the measuring life.
This allowed for grandfathering of existing prescribed annuities and deferred annuities that became prescribed annuities provided the annuity rates were set prior to 2017.
How the Numbers Stack Up
For a life annuity with a three-year guarantee, the differences in life expectancy between the 1971 IAM Table and the Annuity 2000 Table for a few select ages are as follows:
In these examples, the updated mortality table extends life expectancy by approximately two years. The portion of the annual annuity payments considered to be tax-free return of capital is based on the total expected number of annuity payments. Increased life expectancy increases the expected number of payments, which means the total return of capital (effectively the annuity premium) is spread out over more payments. As a result, a smaller portion of each payment will be considered return of capital, and the taxable portion of each annuity payment may increase.
For example, if someone paid $100,000 for a PAC life annuity and the life expectancy using the 1971 IAM Table is 20 years, then the first $5,000 of annual annuity payments ($100,000 / 20 years) would be considered tax-free return of capital. Any annuity payments received above that amount each year would be taxable. However, if the life expectancy with the Annuity 2000 Table is 22 years, then only the first $4,545 of annual annuity payments ($100,000 / 22 years) would be considered tax-free return of capital. Any annuity payments received above that amount each year would be taxable. The net result is the annual amount of tax-free income that an annuitant can receive each year is lower with the Annuity 2000 Table.
The following chart helps illustrate the impact on the taxable portion of an annuity* for the same ages.
As you can see, the changes can increase the taxable portion of the annuity payments and therefore decrease the net cash flow after tax.
It is important to note that the changes do not affect PACs that are term certain annuities, nor does it affect non-prescribed annuities. In addition, the changes don’t impact the gross annual payments.
Prior to 2016, all testamentary trusts could potentially buy a prescribed annuity. After 2015 only testamentary spouse or common-law partner trusts or testamentary trusts that are qualified disability trusts (QDT) for the year in which the annuity is issued can qualify, provided they meet the other conditions of a PAC. A QDT is a testamentary trust, resident in Canada, that jointly elects with one or more beneficiaries eligible for the disability tax credit to be a QDT and that beneficiary hasn’t made that election with any other trust. For more information on this please see AAMOT Prescribed Annuities and Testamentary Trusts (for Advisor use only).
Annuities are not for everyone. However, in the right situation they can be very useful and provide a tax-efficient source of income. Reducing the amount of income a client reports on his or her tax return can not only save taxes but can help preserve income-tested benefits like Old Age Security (OAS). Furthermore, for those 65 or older, taxable income from a non-registered annuity (prescribed or non-prescribed) will qualify for the pension income tax credit and pension income splitting.
For illustration purposes only.
1 In this article prescribed annuity contracts (PACs) refer to annuities purchased with non-registered funds that qualify for prescribed tax treatment.
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.