When it comes to your retirement, the financial products you rely on have complex tax rules — to say the least. If you contribute to a 401(k) plan, Roth account, or non-qualified investment account, your money will be taxed eventually down the road. However, how and when this happens will vary depending on a number of factors, such as what type of account you have, how long you’ve had that account, and your income.
But, if you have a diversified retirement plan, then you also probably need to take into account annuities. For those unfamiliar, annuities can provide a guaranteed lifetime income. In turn, this eliminates the fear of outliving your retirement savings.
But, how are annuities taxed? And, if so, how so?
Getting an idea of how much money you’ll have in retirement will help you make a more realistic retirement plan. And, who knows? It will also help you save some money along the way.
What is an Annuity?
Before going much further, let’s recap what an annuity really is.
An annuity is an insurance contract that is designed to help investors achieve long-term objectives, like a supplemental retirement income. In addition to guaranteed lifetime income, an annuity contract offers tax-deferred growth of any earnings inside the contract.
An annuity is essentially a payment of income that lasts for a set period of time whether that’s a 20-year period or your entire lifetime. When you retire, you might need to replace your regular paycheck with such an income source.
That being said, you are not required to take annuity income. As an example, deferred annuities allow you to deposit money into an annuity contract and decide when (if ever) income payments will begin. On the other hand, immediate annuities begin paying out, well, immediately. In most cases, though, this is within 12 months of purchasing the annuity.
Are Annuities Taxable?
Short answer? You betcha.
One of the most defining features of annuities are that they’re tax-deferred. However, that doesn’t mean you’re completely off the hook.
Rather, taxes aren’t due until you being receiving your annuity payments. Moreover, annuity withdrawals and lump-sum distributions are subject to ordinary income tax. In turn, taxes on capital gains do not apply to them.
But, there’s some other excellent news when it comes to annuities and taxation. Annuities do not have annual taxation like non-qualified investment accounts or savings accounts. That means that the growth on an annuity can compound undisturbed over time.
How Are Annuities Taxed?
How about the money you put into your annuity? Depending on how you fund the annuity, this money is taxed differently. Generally speaking, there are two kinds of annuity accounts: qualified and nonqualified.
Qualified annuity taxation.
An annuity that has been funded with previously untaxed funds is considered a qualified annuity. Usually, a 401(k) or another tax-deferred retirement account, such as an IRA, are used to fund annuities.
You are entirely liable for taxes on annuity income when you begin to receive payments from a qualified annuity. The reason? You haven’t paid taxes on this money, and Uncle Sam is waiting for that tax money.
Non-qualified annuity taxation.
Contracts purchased with money that has been reported to the IRS as income and taxed accordingly are non-qualified annuities.
- The earnings from non-qualified annuities are subject to taxation.
- Depending on how annuity income is withdrawn, non-qualified annuity earnings are taxed differently than a qualified annuity.
- Regardless if it’s a qualified or non-qualified annuity, both types of withdrawals may incur a 10% penalty if you withdraw money before turning 59 ½.
- Furthermore, how does the IRS decide which portion of your payout will be taxed?The answer? It depends on whether you are receiving payments from an income annuity or accumulation annuity.
Taxes on annuities in Roth accounts.
Contributions to a Roth account, such as a Roth 401(k) or Roth IRA, are included in your income when they are made. As such, you won’t have to pay taxes on qualified distributions taken from your annuity since you already paid taxes on those contributions. If you are 59 ½ or older and the account has been open for five years, you can generally make qualified distributions.
An annuity in such an account would potentially provide tax-free income for life, since qualified distributions from Roth accounts are tax-free, and annuities can supply lifelong payments.
How To Calculate The Taxable Amount Of An Annuity
Did you also know that a nonqualified annuity’s tax benefit is dependent on the exclusion ratio? Taxes on periodic payments are measured against the contract’s anticipated return to arrive at a percentage.
To determine the amount of money received tax-free as a return on investment in the contract, multiply the percentage by the periodic payments received under the settlement option. FYI, periodical payments are subject to ordinary income taxation.
You can use the following calculations to calculate the taxable amount of your annuity.
- Investment Amount ÷ Expected Return = Percentage Of Payment That Is Tax-Free
- 100% – Tax-Free Percentage = Percentage Of Payment That Is Taxable
Annuity Early Withdrawal Penalties
If you make a withdrawal on your annuity prior to the designated time period, you may be charged an early withdrawal penalty.
- Typically, if you withdraw money from an annuity before the age of 59 ½, you’ll have to pay a 10% early withdrawal penalty tax. The penalty may apply to the entire distribution amount in the case of an early withdrawal from a qualified annuity. When you withdraw funds from a non-qualified annuity, you will typically have to pay a penalty only on interest and earnings.
- The 10% early withdrawal penalty does not have many exceptions, but you can discuss your specific situation with your tax advisor to see if there are any options to work around this.
- The annuity issuer may also charge a surrender fee on withdrawals in addition to potential tax penalties. When a withdrawal exceeds any penalty-free amount during the surrender charge period, this may occur. Depending on the annuity product you buy, you may be charged a surrender charge. To find out how much the surrender charge is, contact the annuity issuer.
Annuity Payout Taxation
Generally speaking, each monthly annuity income payment from a non-qualified plan consists of two parts, according to the General Rule for Pensions and Annuities by the Internal Revenue Service. Annuities are considered tax-free when you receive the tax-free portion of your investment. As for the rest? This would be your taxable balance or your earnings.
Annuities are designed as a long-term investment where you will receive income payments at a later date. And, that’s why you get penalized for withdrawals. But, if you don’t make an early withdrawal, the principal amount and its tax exclusions will be equally distributed over the expected number of payments. But, the remainder of each payment is considered income and will be subject to tax.
Tax Rules for Inherited Annuities
As with everything described above, the tax rules apply when you inherit an annuity:
- Distributions from qualified annuities are fully taxable.
- In a non-qualified annuity, a lump-sum withdrawal (withdrawal) is divided into earnings and basis. After the earnings have been exhausted, the basis emerges, which is followed by the earned income (and taxed).
- Many annuitized contracts cease paying after the death of the annuitant (the person entitled to receive benefits from the annuity). Nevertheless, if a contract continues to pay income, the exclusion ratio rules remain unchanged.
When you inherit an annuity, there may be additional rules and opportunities. If you own qualified assets, you may be able to roll them over to an IRA, or the funds may have to be distributed within a specified period of time. You can avoid tax penalties by checking with a CPA about the requirements.
With respect to retirement plans, contributions to qualified annuities are deductible up to IRS limits. Or, more succintly, qualified annuities have the same deductibility limits as IRAs, 401(k)s, 403(b)s and other qualified plans.
For IRA deductibility limits, consult the IRS website. Just note, however, that premium payments to nonqualified annuities do not qualify.
A lump-sum payout from your IRA, 401(k), 403(b) or pension plan can be rolled over into a qualified annuity without incurring taxes.
A 1035 exchange allows nonqualified annuities to be exchanged for another nonqualified annuity tax-free. If you do not like the features of an annuity, you can trade it for one that offers better features or pays a higher yield.
Long-term Care Tax Benefits
Tax-free withdrawals can usually be made from interest paid on long-term care insurance policies. And, considering that these costs are rising, this can be a great relief to your retirement savings.
Qualified Immediate Annuities
The total of the payments received each year from pretax qualified annuities is taxable since the funds in those annuities are not taxed. As such, these amounts are included in your required minimum distributions (RMD).
You Can Reduce or Defer RMDs with a QLAC
The qualified longevity annuity contract, or QLAC, is a qualified annuity that meets IRS requirements. By doing so, you can defer up to 25% of RMDs until age 85 and lower your taxes until payment begins. Be aware that you will have to withdraw money from your IRA at some point anyway, so QLAC income is 100% taxable.
You can contribute up to 25% of your IRA balances or $135,000, whichever is less, to a QLAC during your lifetime.
Frequently Asked Questions About Annuity Taxation
1. Do you pay taxes on annuities?
Until you withdraw money from your annuity or begin receiving payments, you won’t owe income taxes. If you purchased the annuity with pre-tax money, the money you withdraw is taxed as income. A tax would only be due on earnings if the annuity was purchased with post-tax funds.
Remember, an advantage of purchasing annuities is that they can grow tax-deferred while accumulating.
2. Which type of annuity will immediately tax any interest earned?
Once the interest is taken out of an annuity, it becomes taxable. In the case of a one-time distribution from an annuity not in a retirement account, interest earnings are treated according to the last-in, first-out (LIFO) rule.
Upon receiving income from an annuity in a non-Roth retirement account (self-directed withdrawals or annuity payments), your income will be taxed as income.
3. Is it possible to determine an annuity’s taxation by using the General Rule?
Annuity payments or distributions can be excluded from income if you’re eligible to use the General Rule. You can use the IRS worksheets from Publication 939 to calculate the appropriate amount. You can verify that the claim is correct by consulting a professional tax preparer or CPA.
4. How much tax is paid by beneficiaries on inherited annuities?
There’s no way to completely avoid this. Taxes are imposed on inherited annuity earnings. However, the taxed amount will vary on factors like the payout structure and whether the beneficiary is the surviving spouse or otherwise related to the annuity owner.
5. What percentage of your annuity should be withheld as tax?
Again. you do not pay any taxes until you start receiving annuity payments or income streams. The taxable amount of your income will depend on whether the annuity was purchased using qualified (pre-tax) or nonqualified (post-tax) funds. At the time, your tax bracket and income may influence your withholding strategy.