How Are Annuities Taxed?

Video Transcript

Are you considering an annuity but unsure how taxes come into play? You're not alone. Annuities can be powerful financial tools, but the tax rules can be a bit complex. Today we will break down exactly how annuities are taxed, whether you’re working with qualified or nonqualified funds. Annuities grow tax-deferred, which means you won’t owe taxes on your earnings until you start withdrawing funds. Sounds great, right? But here’s the catch — how and when you take those withdrawals, and what type of annuity you own, will determine your tax bill.

Annuities are either qualified or nonqualified . Qualified annuities are funded with pre-tax dollars, usually through retirement accounts like IRAs or 401(k)s. When you withdraw money from these, it’s all taxed as ordinary income — both your original contributions and any growth. Why? Because none of it has been taxed yet.

Nonqualified annuities are funded with after-tax money. The IRS uses a “last in, first out” approach which means your earnings come out first and are taxed as income. Only after all the earnings are withdrawn do you start receiving your tax-free original contributions.

If you choose to annuitize — that is, turn your annuity into a series of regular payments — your taxes will get split too. Each check includes both taxable interest and a tax-free return of your original investment. This breakdown is called the exclusion ratio. But once you’ve lived beyond your expected lifespan, the whole payment could become taxable.

Roth annuities work a bit differently. Since they’re funded with after-tax dollars, both your contributions and potentially even your earnings can be withdrawn tax-free as long as you follow IRS rules. That typically means waiting until age 59½ and holding the account for five years.

Watch out for tax penalties. Here’s where it gets tricky. If you pull money from your annuity before age 59½, you may face a 10% early withdrawal penalty on top of regular taxes. And your beneficiaries could owe income tax on gains on nonqualified annuities due to no “step-up” in cost basis.

In conclusion, talk to a professional first as annuities offer valuable tax benefits, but there are some important nuances that can lead to unexpected tax consequences if you’re not prepared. Whether your annuity is part of a retirement plan or a personal investment, the key is to understand the rules or better yet, work with a financial professional who does.

Ready to learn more and see how annuities can fit into your retirement strategy? Get more answers to your financial questions at WesternSouthern.com or call now or start your free plan today.

Annuities provide some tax benefits because earnings grow tax-deferred. However, you will have to pay taxes on withdrawals from an annuity contract. It is important to understand how annuities work and when taxes may apply. Here is what to know.

Are Annuities Taxable?

Annuities offer tax-deferred growth. When you earn interest in an annuity, you usually do not need to report those earnings or pay income tax each year. This allows your money to stay invested and continue to grow over time.

At some point, you will pay income taxes on withdrawals from an annuity contract. The way taxes apply depends on the type of annuity you have, how you take money out, and when you take it out. This is a general overview, so it may help to speak with a tax professional before making decisions.

How Are Annuities Taxed?

Several factors can affect how withdrawals and income payments from an annuity are taxed.

Qualified Funds

If you use pre-tax money in an individual retirement account (IRA) or 401(k), you pay taxes when you withdraw funds. The same rule applies if you fund an annuity with pre-tax money.

Because you have not paid taxes on that money yet, withdrawals are taxed as income. These are called qualified annuities. They are often part of employer-sponsored retirement plans, and the full amount you withdraw is generally subject to income tax.

Nonqualified Funds

You can also fund an annuity with after-tax dollars. These are called nonqualified annuities. The way they are taxed depends on how you take money out.

Withdrawals

If you take money out of a nonqualified annuity, the IRS follows a last-in, first-out (LIFO) method. This means earnings are withdrawn first.

For example, if you withdraw $10,000 and your annuity has at least $10,000 in earnings, the full amount is taxed as ordinary income. After all earnings are withdrawn, any remaining withdrawals are considered a return of your original investment and are not taxed.

Annuitized Payments

If you turn your annuity into a stream of income payments, each payment includes both taxable and non-taxable portions. This is called the exclusion ratio. Part of each payment represents your original investment and is not taxed. The rest represents earnings and is taxed as income. For example, if you receive $1,000 per month, $800 may be non-taxable while $200 is taxable.

If you live beyond your expected lifespan, future payments may become fully taxable.

Roth Accounts

Some annuities can be set up as Roth accounts, similar to Roth IRAs. These are funded with after-tax dollars. Because of this, withdrawals of your original contributions are not taxed. You may also be able to withdraw earnings tax-free if certain IRS rules are met. In most cases, you must be at least age 59½ and have held the account for at least five years before withdrawing earnings.

What Are Some Annuity Tax Pitfalls?

Annuities can offer tax advantages, but there are important rules to understand.

Penalty Taxes

Like other tax-deferred retirement accounts, annuities may have penalty taxes if you withdraw money too early. If you take money out before age 59½, you may owe a 10% penalty in addition to income taxes.¹ Some exceptions may apply. It may help to check with a tax professional before making a withdrawal.

Income Tax

In some cases, nonqualified annuities may result in higher taxes for you or your beneficiaries.

For example, some investments outside of annuities may receive a step-up in cost basis at death. This can reduce taxes for beneficiaries. Annuities do not receive this same treatment, so earnings may still be taxed.

Also, some investments may qualify for long-term capital gains tax rates, which are often lower than ordinary income tax rates. Annuity withdrawals are generally taxed as ordinary income. Even so, other features of annuities may still make them a useful option depending on your situation.

Tax Benefits Are Complicated

Annuities can help delay taxes and provide structured income. It is important to review how they fit into your overall goals. Working with a financial professional and tax advisor can help you understand how annuities may affect your taxes and help you avoid unexpected costs.

Sources

1. Topic No. 558, Additional Tax on Early Distributions From Retirement Plans Other Than IRAs. https://www.irs.gov/taxtopics/tc558.