A purchased life annuity (PLA) is a type of annuity that provides a guaranteed income for life or a fixed term, in exchange for a lump sum. Unlike pension annuities, PLAs are bought with money that has already been taxed, such as savings, inheritance, or proceeds from a house sale. But how are purchase life annuities taxed and what are the benefits and drawbacks of this option?

Taxation of PLAs

The income from a PLA is partly taxable and partly tax-free. The tax-free part is called the capital element, the exempt sum, or the exempt proportion, depending on the circumstances. This is the amount of each annuity payment that is considered to be a return of the original capital invested. The remaining part of each annuity payment is deemed to be interest and is taxable as savings income.

The amount of the capital element or the exempt sum is calculated by dividing the purchase price of the annuity by the life expectancy of the annuitant, according to prescribed mortality tables. The exempt proportion is the percentage of the annuity payment that is tax-free and is fixed at the start of the annuity.

For example, if a 65-year-old man buys a PLA for £100,000 that pays him £5,000 per year, his life expectancy according to the tables is 20 years. Therefore, the capital element of each annuity payment is £100,000 / 20 = £5,000. This means that the entire annuity payment is tax-free. However, if the annuity pays him £6,000 per year, the capital element is still £5,000, but the interest element is £1,000, which is taxable.

Benefits and Drawbacks of PLAs

One of the main benefits of PLAs is that they offer a secure and predictable income for life or a fixed term, which can help to cover essential living expenses and provide peace of mind. PLAs also have a lower tax liability than pension annuities, as part of the income is tax-free. This can increase the net income and make PLAs more attractive for higher-rate taxpayers or those who have used up their personal allowance.

However, PLAs also have some drawbacks. The income from a PLA is usually fixed and does not increase with inflation, which means that the purchasing power of the income may decline over time. PLAs also have no flexibility or access to the capital once the annuity is purchased, which means that the annuitant cannot change their income level or withdraw money if they need it. PLAs also have no death benefits, unless the annuity has a guarantee period or a joint life option, which will reduce the income.

Conclusion

PLAs are a type of annuity that provide a guaranteed income for life or a fixed term, in exchange for a lump sum. PLAs are partly taxable and partly tax-free, depending on the amount of the capital element or the exempt sum of each annuity payment. PLAs offer a secure and predictable income, but also have some limitations, such as lack of inflation protection, flexibility, access, and death benefits. Therefore, PLAs may not be suitable for everyone and should be considered carefully before making a decision.

Are Purchased Life Annuities Taxable
Are Purchased Life Annuities Taxable