Are pensioners in India paying taxes on savings that have already been taxed?
Imagine you have just retired and have received money from various retirement benefits and superannuation funds. After settling taxes you decide to buy an annuity that starts making payment from the very 1st year. This investment will give you a fixed amount of money every year, for the rest of your life. This type of annuity is called Immediate Annuity.

An annuity pays fixed cash flow till the death of the annuitant and this payment is based on the buyers age, prevailing interest rate and the amount invested. If you are 60 and if you were to purchase an annuity for Rs 10 lacs, then you may get around Rs 95,000 per year till you are alive. This payment stops on the annuitants death.

These 10 lacs used in purchasing the annuity is coming from your income on which you have already paid taxes. If you look at an annuity, it appears like an EMI based loan. You are extending a loan of 10 lacs to an insurance firm and it offers you an annual "EMI" (it is equated annual instalments as we are looking at annual payments) of Rs.95,000 every year.

We know that EMI payment consists of part interest and part principal repayment. Can we not say the same is true for a simple annuity? We get a statement of what amount of EMI goes towards interest payment and what goes towards principal repayment. every year. We use this split for filing tax returns. We cannot show the sum of entire EMIs as interest expense. Only the interest portion can be shown as an expense and that reduces the taxable income resulting in a lower tax.

However, in case of an annuity, the entire EMI is taken as income and is taxed. This means that the annuitant pays tax on the return of the principal too. It is like investing 10 lacs in a bank fixed deposit and when a bank gives back 10 lacs + interest earned on the deposit you pay tax on the whole amount of 10 lacs + interest and not just on the interest earned.

This seems unfair for a retired person who may have limited source of income.

Why cant a company offering annuity, gives a break up of principal and interest, the way housing finance companies and banks do it on our home loans.

The key difference between an EMI based loan and an annuity is that the loan has a prespecified maturity date. This is the last EMI payment when the entire loan and interest has been repaid. In case of an annuity, the maturity date is not certain, as it is dependent on how long the annuitant lives. Since the maturity date is unknown, mathematically it is difficult to split EMI into principal and interest. Does this justify having to pay tax on repayment of principal?

Are there any methods that can be used to split the annuity payment into principal repayment and interest? Let me suggest few solutions that make intuitive sense.

One option is the use of expected life. For instance, if the expected life is 80 then our investor has hypothetically 20 years of life left. 10 lacs investment is divided into 20 equal parts of Rs 50,000 each. Hence out of 95,000 annuity payment 50,000 will be treated as principal repayment and only the remaining 45,000 will get taxed.

Another option is to not pay any tax on annuity payments received until the purchase price is fully recovered and start paying tax subsequently. Thus, the investor, in this case, will pay taxes only in the 11th year. In 10 years he will get back 95,000 x 10 = 9.5 lacs. The remaining 50,000 would come from the next years payment. Hence in the 11th year, 50,000 from the annuity payment will go towards principal repayment and remaining 45,000 would attract taxes. 12th year onwards the entire amount will be subjected to tax.

Another solution is that annuity companies that offer this simple annuity also offer a product that returns the purchase price to nominees on the death of the annuitant. Lets say this product offers annuity payment of Rs 75,000 for a purchase price of 10 lacs for a person who is 60 years old.

The key difference between these 2 products is the return of the purchase price, which is the principal amount. This product works simply like a fixed deposit with a maturity date that extends all the way to the annuitants death. Hence one can say that the difference between 95,000 payments in case of a simple annuity and 75,000 represents the value of principal repayment in instalments. This difference may be reduced from the annuity payment and rest may be taxed.

Hope the government recognizes this and takes steps to resolve this issue, as it is trying to promote annuity as a way of earning a constant stream of money for retirees.