Tax nuances are a complex part of any financial tool you rely on for retirement. Take a 401(k) plan as an example. These types of retirement plans are tax-deferred. This means that until you withdraw funds from the account, you will not pay taxes on the money you contributed, as well as the gains, interest, or dividends the plan has generated. As such, a 401(k) plan isn’t just a solid way to save for retirement, it can help reduce your tax bill down the road.
It’s worth pointing out, though, that how your various investments accounts will be taxed is based on a number of factors. As well as the type of account, how and when you withdraw money from it varies depending on how long you’ve had the account. And, even how much income you make may play a role.
That being said, annuities are yet another tool commonly included in diversified retirement plans. Annuities, which provide guaranteed lifetime income after retirement, can help you protect your assets if you outlive them.
But how are annuities taxed? You can better predict how much money you’ll likely have in retirement by knowing how they are taxed. So, to help get a better grasp on this, let’s take a deeper dive into how annuities are taxed.
Are Annuities Taxable?
Let’s start with the good news. All annuities grow tax-deferred. The benefit is similar to a 401(k) in that taxes aren’t due until you begin receiving income payments from your annuity. What’s more, an annuity’s growth increases undisturbed over time, unlike that of non-qualified investment accounts and savings accounts. And, as a result, grows more.
Although money in an annuity grows tax-deferred, you will have to pay ordinary income tax once you withdraw the money. To be blunter, an annuity isn’t a way to avoid taxes. Again, it’s just that taxes aren’t due until you being receiving your annuity payments.
Also, it’s worth mentioning that income derived from an annuity or lump-sum distribution is taxed as ordinary income. And, this income is not taxable as capital gains.
Taxation of Annuities
Depending on the type of annuity you have and the time at which you withdraw funds, the impact on your retirement savings and income may be different. Additionally, considering annuities’ tax rules is important before purchasing one.
Qualified vs. non-qualified annuities.
An annuity’s tax status depends on the type of annuity you buy. And, this boils down to wheter the annuity is qualified or non-qualified.
In short, annuities funded with pre-tax dollars are called qualified annuities. Conversely, annuities funded with post-tax dollars are known as non-qualified annuities. Also, the type of annuity you own will affect how your payouts are taxed.
- Funding. Generally, qualified annuities are purchased with pre-tax dollars.
- Distributions. Required Minimum Distributions (RMD) are applicable to qualified annuities. As such, by April 1st of the year following your 72nd birthday, you’re required to start taking withdrawals from a qualified annuity.
- Payouts. All distributions will be subject to ordinary income taxes. Purchasing annuities with a Roth IRA or 401(k) can, however, result in a tax-free income stream in some cases.
- Additional considerations. An annuity will not provide additional tax-deferral benefits for a retirement plan or IRA if it is held to fund the retirement plan or IRA.
- Funding. The growth of nonqualified annuities is tax-deferred and funded with after-tax dollars.
- Distributions. The Required Minimum Distribution does not apply to non-qualified annuities. Any interest or earnings within a non-qualified annuity will be distributed before any premium or principal distributions.
- Payouts. Interest (or earnings) are taxed as ordinary income, but the initial deposit or premium is not taxable.
Non-qualified annuities are taxed based on what is called the exclusion ratio. In addition to determining taxable annuity income, exclusion ratios determine how much of it is tax-free. Essentially, it involves determining which portion of money withdrawn or paid from an annuity is taxable and which part is not.
Exclusion ratios take into account the principal used to purchase the annuity. It also factors how long the annuity has existed, as well as the interest earned. And, annuity payments received after an annuitant reaches the calculated life expectancy are fully taxable.
Why is this the case? Well, the exclusion ratio is calculated to spread the withdrawal of principal over the annuitant’s lifetime. In the event that any remaining income payments or withdrawals remain after all principal has been accounted for, they are considered earnings.
Annuity early withdrawal penalties.
It’s important to keep in mind that an annuity may be a worthwhile addition to your retirement plan. However, early withdrawal penalties will apply if you withdraw money prior to the designated time period.
- Early withdrawal penalties typically apply to annuity withdrawals made before the age of 59 ½. An early withdrawal penalty may apply to the entire distribution amount from a qualified annuity. Typically, only earnings and interest will be subject to penalty if you withdraw money early from a non-qualified annuity.
- Although there are a limited number of exceptions to the 10% early withdrawal penalty, you can consult your tax advisor about potential options based on your specific situation. For instance, this penalty may be waived due to a medical emergency that required you to make an early withdrawal.
- The annuity issuer may also charge surrender charges for withdrawals in addition to tax penalties. During the surrender charge period, a penalty-free amount may be exceeded if withdrawn. Before withdrawing money from an annuity, be sure to speak to the annuity issuer about surrender charges.
The taxation of withdrawals and loans is based on a Last-In-First-Out (LIFO) system. What does the LIFO method mean? Simply put, any interest earned will be distributed from the annuity first (before your premium is paid). As a result, tax is charged on the gainable portion first.
Withdrawals consist of;
- Penalty-free withdrawals
- Systematic withdrawals
- Lifetime withdrawals from an income rider
Inherited annuity taxation.
Taxes are the same if you inherit an annuity as the beneficiary. As such, a principal that is paid into an inherited or purchased annuity that has already been taxed will not be subject to tax.
The principal and earnings that were not taxed will be subject to income taxation. However, annuity income payments with the previously taxed principal are excluded from federal income tax requirements. If you recall, such payments are referred to as the exclusion amount.
How To Minimize Taxes In Retirement
There’s an assumption that your taxes will be lower in retirement. But, believing this myth can be a costly mistake. Thankfully, there are ways to minimize your taxes in retirement — which can be all the difference in the world when on a shoestring budget.
The first step is to convert a traditional IRA into a Roth IRA. Why? With a Roth IRA you can make tax-free withdrawals. Also, the amount of taxes you must pay for those conversions would be minimized if you timed a series of conversions to coincide with years when your tax bracket is lower.
Next, maximize Roth IRA contributions since all earnings generated by these accounts are tax-free. Third, maximize nonqualified tax deductions since only interest is taxable.
Last but not least, if your goal is to keep up with inflation over the years, you should attach a cost of living rider. Sure, you cannot avoid paying sales tax. But, using the inflation protection will help maintain the value of every dollar spent over the years.
Also, you might be able to use a long-term care annuity to pay for nursing home expenses. What’s more, you can use it to cover home health care or assisted living expenses.
How To Calculate The Taxable Amount Of An Annuity
Why would you want to do this? Because it will help you plan accordingly so that you’ll have to pay the taxable amount of your annuity. After all, the last thing you want is to get on the bad side of the IRS.
You will notice that any quotes you receive for immediate or deferred income annuities include a section listing the taxable portion of your payments. But, you may want to know how your insurance company determines which portion of your payments you should be taxed just to play it safe.
Suppose you’re 65 years old and you’re considering investing $100,000 in an immediate or deferred income annuity. And, the insurance company has agreed to pay you $550 a month for the rest of your life.
On page 26 of IRS Publication 939, Table V (described above), we find that the so-called ‘multiple’ for persons 65 and over is 20. FYI, your life expectancy is referred to by the IRS as “multiple.” To put that another way, the IRS expects an individual aged 65 to live another 20 years.
Multiplying your monthly income (which we assumed would be $550) by 12 months, you come up with an annual income of $6,600. In our example, we take $6,600 annual income and multiply it by 20 life expectancy “multiples” from the IRS and get $132,000.
Based on an annuity investment of $100,000, the IRS assumes that a 65-year-old will receive $132,000 ($6,600 x 20) over their lifetime. However, the amount that you receive will vary according to factors like your health and longevity.
Alternatively, you can use the following formula to determine your annuity’s taxable amount.
- Investment Amount ÷ Expected Return = Percentage Of Payment That Is Tax-Free
- 100% – Tax-Free Percentage = Percentage Of Payment That Is Taxable
Frequently Asked Questions About Annuity Taxation
1. Do you pay taxes on annuities?
You sure do. But, you don’t have to pay income taxes on annuities until you receive payments — or make a withdrawal. If you purchased the annuity using pre-tax funds, your withdrawal will be taxed as income. Taxes are only imposed on earnings if the annuity was purchased with post-tax funds.
Keep in mind that tax-deferred growth is one of the benefits of purchasing annuities during the accumulation phase.
2. How much tax should you withhold from your annuity?
Until you receive your annuity distributions or stream of income, taxes are deferred. Based on whether you purchased the annuity with qualified (pre-tax) or nonqualified (post-tax) funds, your income will be taxable. According to your overall income and tax bracket at that time, you may decide how much to withhold.
3. How do I use the General Rule to determine an annuity’s taxation?
A portion of an annuity payment or distribution can be excluded from your income if you qualify to use the General Rule. You can use IRS Publication 939 worksheets to determine the appropriate amount. If you claim the correct amount, your CPA or tax preparer can verify it.
4. What type of annuity will cause immediate taxation of interest earned?
Taxes will only apply to interest earned within an annuity once it is withdrawn. Interest earnings on one-time distributions from an annuity, which isn’t held as a retirement account, are treated as LIFO (last-in-first-out). If you receive an annuity payment or a self-directed withdrawal from a non-Roth retirement account, you are required to declare it as income in the year it is received.
5. Do beneficiaries pay tax on inherited annuities?
Yes, any earnings from inherited annuities are subject to taxation. Depending on the payout structure, as well as the beneficiary’s relationship to the annuity owner, the taxed amount could differ.
Even though you can’t avoid taxes on inherited annuities, you can prevent early withdrawal penalties if you don’t make withdrawals before age 59 ½.