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 Only after all the earnings are withdrawn do you start receiving your tax-free original contributions.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 Since they’re funded with after-tax dollars, both your contributions and potentially even your earnings can be withdrawn tax-free as long as you follow IRS rules.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's important to learn how annuities work and understand when you might pay taxes. Here is some information to keep in mind.

Are Annuities Taxable?

Annuities offer tax-deferred growth. When you earn interest in an annuity, you typically don't need to report those earnings and pay income tax on the earnings every year. You can keep funds in your account to reinvest and compound. Growth in your annuity is insulated from personal income taxes.

At some point, you will have to pay income taxes on withdrawals from an annuity contract. The mechanics depends on the type of annuity you have, how you access your funds, and when you access your funds. While this is an overview of annuity taxation, consult a tax professional before you make any decisions.

How Are Annuities Taxed?

When you have an annuity, there are a number of details that can affect the taxation of withdrawals and income payments you receive.

Qualified Funds

If you put pre-tax money into an individual retirement account (IRA) or 401(k), you pay taxes on withdrawals, and this is true if you fund an annuity with pre-tax money. You've never paid tax on that money, so you'll owe income tax on any funds you take out of your annuity. These annuities are known as "qualified" annuities, and often set up by employers for employees as part of a qualified retirement plan and entire amount in your contract is subject to income tax.

Nonqualified Funds

You can also set up an annuity using after-tax dollars, known as nonqualified annuities, and their tax treatment depends on a couple factors:

• Withdrawals: If you take cash out of a nonqualified annuity, the IRS considers the funds last in, first out (LIFO). For example, you might ask for $10,000 for a home improvement project. If you have at least $10,000 of earnings in your annuity, the entire $10,000 is treated as income, and would typically be taxed as ordinary income. After you exhaust the earnings in your account, you receive a tax-free return of your original lump sum.
• Annuitized payments: If you convert your funds into a guaranteed stream of income payments by annuitizing, those payments are split into taxable portions and tax-free portions. The taxable to nontaxable portion of each payment is known as the exclusion ratio. Each payment returns a portion of the money that has already been taxed and a portion of interest, which is taxable. For example, if you receive $1,000 per month, $800 of each payment might be tax-free, while the remaining $200 is taxable income. Eventually, if you outlive your statistically determined life expectancy, the entire amount of each payment could become taxable.

Roth Accounts

Some annuities can also be set up as a Roth account, similar to Roth IRAs. Since the annuity would have been funded with after-tax money, you would not owe taxes on this when withdrawn. Since it is classified as a Roth, you can also potentially make tax-free withdrawals of the growth from your account. To do so, you must follow several IRS rules. In general, you must wait until at least age 59 1/2 to withdraw earnings from your account, and your Roth must be open for at least five years.

What Are Some Annuity Tax Pitfalls?

While annuities can help you defer and manage taxes, you need to understand some of the tax implications.

Penalty Taxes

Just like tax-deferred retirement accounts, annuity distributions may incur additional penalty taxes — on top of any income tax — if you don't follow certain IRS rules. If you withdraw money from an annuity before the age of 59 1/2, you may have to pay a 10% penalty on the amount withdrawn along with paying taxes on it. However, there are some scenarios in which you may be exempt from this penalty.¹ Check with a tax preparer or CPA before you withdraw funds from an annuity.

Income Tax

In some cases, nonqualified annuities may cause you or your beneficiaries to pay income tax that could potentially be avoided. For example, stocks in a nonqualified annuity may "step-up" in cost basis (the original after-tax sum paid into a nonqualified annuity) at your death, while any gains in an annuity remain taxable to beneficiaries. Likewise, taxable investments outside of annuities might receive long-term capital gains treatment instead of being taxed at ordinary income tax rates. Still, the other features of an annuity may outweigh income tax treatment.

Tax Benefits Are Complicated

Annuities can be tools for deferring and managing taxes. Evaluate how best to structure your retirement, charitable giving and other financial goals with the help of a financial professional and tax advisor. A tax-aware strategy could help you take advantage of annuity benefits and avoid surprises down the road.

    Annuities are taxed differently based on whether they are qualified or nonqualified. Start Your Free Plan  

Sources

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