Are Annuities Taxable?

The answer is complicated (but generally, yes they are)

Let’s assume that you have already done your research on the workings of an Annuity and you are almost convinced that it is a good investment for you and your future plans.  Now, let’s consider if the taxability of this product is what you are looking for.

First, if you purchase an annuity with pre-tax dollars, payments from the annuity are fully taxable as income. But, if you buy an annuity with after-tax funds, you are required to pay taxes only on the earnings (ie, profit).  Annuities offer tax-deferred growth, which means taxes on annuities are not due until you withdraw money from the annuity.  One of the main tax advantages of annuities is they allow investments to grow tax-free until the funds are withdrawn.  This includes dividends, interest and capital gains, all of which may be fully reinvested while they remain in the annuity.  This allows your investment to grow without being reduced by tax payments.

But this seemingly simple perk is accompanied by a raft of complicated rules about what funds are taxed, how they are taxed and when they are taxed.

Because of the complexity, it is best to consult with a tax professional when purchasing an annuity and before withdrawing any funds.

Are Annuities Taxable?

Annuities are tax deferred.  But that does not mean they are a way to avoid taxes completely.  What this means is taxes are not due until you receive income payments from your annuity.  Withdrawals and lump sum distributions from an annuity are taxed as ordinary income.  They do not receive the benefit of being taxed as capital gains.

How are Annuities Taxed?

When it comes to taxes, the most important piece of information about your annuity is whether it is held in a qualified or non-qualified account. Remember, qualified is that the taxes are behind the tax wall and are allowed by IRS to be deferred.  Non-qualified means that the taxes have already been paid. In this case, the earnings (or profits) are taxable.

Qualified Annuity Taxation

If an annuity is funded with money on which no taxes have been previously paid, then it is considered a qualified annuity.  Typically, these annuities are funded with money from 401ks or other tax-deferred retirement accounts, such as IRAs.

When you receive payments from a qualified annuity, those payments are fully taxable as income.  That is because no taxes have been paid on that money.

But annuities purchased with a Roth IRA or Roth 401k are completely tax free if certain requirements are met.

Non-Qualified Annuity Taxation

If the annuity was purchased with after-tax funds, then it is non-qualifed.  Non-qualifed annuities require tax payments on only the earnings (or profits).

The amount of taxes on non-qualifed annuities is determined by something called the exclusion ratio.  The exclusion ratio is used to determine what percentage of annuity income payments is taxable and which is not.  The idea is to determine the amount of a withdrawal or payment from an annuity is from the already-taxed principal and how much is considered taxable earnings.

The exclusion ratio involves the principal that was used to purchase the annuity, the amount of time the annuity has existed and the interest earnings.

If an annuitant lives longer than his or her actuarial life expectancy, any annuity payments received after that age are fully taxable.

That is because the exclusion ratio is calculated to spread principal withdrawals over the annuitant’s life expectancy.  Once all the principal has been accounted for, any remaining income payments or withdrawals are considered to be from earnings.

Exclusion Ratio Example

  • Your life expectancy is 10 years at retirement.
  • You have an annuity purchased for $40,000 with after-tax money.
  • Annual payments of $4,000 – 10 percent of your original investment – is non-taxable.
  • You live longer than 10 years.
  • The money you receive beyond that 10-year-life expectation will be taxed as income.

Annuity Withdrawal Taxation

How and when you withdraw funds from your annuity also affects your tax bill.

In general, if you take money out of your annuity before your turn 59 ½, you may owe a 10 percent penalty on the taxable portion of the withdrawal.

After that age, if you take your withdrawal as a lump sum, you have to pay income taxes that year on the entire taxable portion of the funds.  If money is left in your annuity account, the IRS considers the first and subsequent withdrawals to be interest and subject to taxes.

Annuity Payout Taxation

According to the General Rule for Pensions and Annuities by the Internal Revenue Service as a general rule each monthly annuity income payment from a non-qualified plan is made up of two parts.  The tax-free part is considered the return of your net cost for purchasing the annuity.  The rest is the taxable balance, or the earnings.

When you receive income payments from your annuity, as opposed to withdrawals, the idea is to evenly divide the principal amount – and its tax exclusions – out over the expected number of payments. The rest of the amount in each payment is considered earnings subject to income taxes.

Inherited Annuity Taxation

If you are the beneficiary and inherit an annuity, the same tax rules apply.  The main rule about taxation with an inherited annuity or one that is purchased is that any principal that is funded with money that was already subject to taxes will not be taxed.  Principal that was not taxed and earnings will be subject to taxation as income.  The amount of previously taxed principal included in each annuity income payment is considered excluded from federal income tax requirements.  This is known as the exclusion amount.

In Summary

If you just take the opinion of Mom, Dad, Gramma, Uncle Joe, Preacher Mike, Mr. Ramsey, Mr. Howard or even simply the Web then you are not making the best, most educated decision.  Do your due diligence and ensure that you talk to an industry professional.  What happens if Uncle Joe tells you what happened to him 30 years ago and you should “never invest in one of those annuity things”. Well, first of all what is his profession and how old was the product he purchased at that time.  Could things have changed in those years?  How about being at a family reunion and Gramma tells you that she just heard Mr. Howard talking about how some people lost money when they annuities a few years ago.  Even though you love Gramma, is she a financial professional with current experience and education.  So, in summary, annuities can be taxable in the right situation.  This is definitely something that you need to have reviewed by your Financial Professional.  Best of luck on your investment.

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