Annuities & taxes: Qualified vs. nonqualified, rules, penalties & more

Annuities can provide a strong financial backbone to a purposeful, fulfilling retirement. You purchase an annuity with a lump sum or series of payments. In turn, you'll receive income in retirement. But as with other forms of income, taxes will affect your annuity payments.

How your annuities are taxed will depend on your type of annuity, when you decide to receive income payments, and how you fund it—with pre- or post-tax dollars. Let's cover the basics so you can make informed and confident retirement savings decisions.

After you purchase an annuity, you could see its value grow over time. This would happen during the accumulation phase, when you're contributing money through a series of payments or a lump sum. Any growth is tax-deferred. So taxes on earnings or interest aren't due until you begin receiving payouts (usually, after you retire).

It's important to note that only deferred annuities have an accumulation phase. With these annuities, you receive payouts in the future, leaving time for growth potential. An immediate annuity doesn't have an accumulation phase because it converts one lump-sum contribution into a stream of income, with payouts starting within a year.

During the distribution phase (also known as the payout period or annuitization phase), you begin to receive payouts, usually monthly or annually. The tax treatment depends on whether you have a qualified or nonqualified annuity.

A qualified annuity is funded with pre-tax money. You generally purchase qualified annuities in a tax-advantaged retirement account like a traditional IRA or 401(k). Once you start payouts, the entire amount—your original contributions and any earnings—is considered taxable income. The amount of tax you owe depends on your tax rate in the year you receive the distribution.

It's also important to note that if you withdraw money from an annuity before age 59½, you'll likely owe a 10% early withdrawal federal tax penalty in addition to regular income tax. Some exceptions to this rule exist, such as if you become disabled or use the money to pay for medical expenses exceeding 7.5% of adjusted gross income.

A nonqualified annuity is funded with after-tax dollars, meaning you purchase these annuities with money on which you've already paid income taxes. When you take distributions, only the earnings are subject to income tax. Your original contributions come back to you tax-free because you've already paid taxes on that money.

However, it's important to note that you don't have a choice in how much earnings versus contributions you withdraw. For withdrawals, earnings will be paid out first, meaning you will pay taxes on a full withdrawal amount until all the earnings have been paid out of the annuity. If you elect to set up a guaranteed annuity payout stream, each payment uses an "exclusion ratio" to determine how much of your payout is considered income versus how much is a nontaxable return of your principal. Your insurance company should provide you with a form to complete your tax return that indicates how much is taxable.

For example, say you purchase an immediate annuity with a fixed period of 20 years for $100,000 at age 65. The annuity contract will pay out $550 monthly for the next 20 years (240 months). Dividing your initial principal of $100,000 over 240 months would equal around $417 per month. However, your contract entitles you to $550 per month.

As a result, $417 out of your $550 monthly payment wouldn't be taxable, as the IRS would consider it a tax-free return of principal. You only would be responsible for paying tax on $133. This means your exclusion ratio is 75.8% ($417 / $550) because this percentage of your monthly annuity payment is excluded from your taxable income.

Like qualified annuities, withdrawing money from a nonqualified annuity before age 59½ may result in owing a 10% early withdrawal federal tax penalty and income tax on the earnings. However, the penalty applies only to the taxable portion of your withdrawal—not your tax-free return of principal. Of course, earnings are paid out of the annuity first.

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Are you considering an annuity?

As with any product, there are pros and cons of annuities. Understanding them can help you decide whether an annuity is a good retirement solution for you.

Dive deeper

Different types of annuities come with their own tax consequences. The type of retirement account where you hold your annuity—such as an IRA or 401(k)—also plays a role. Let's look at a few common scenarios and the resulting effect on taxes.

When you put money into an IRA, your contributions—which you may use to purchase the annuity—are tax-deductible, provided you meet the income qualifications. Any growth inside the IRA is tax-deferred, which means you'll pay no taxes on the gains until you take distributions. There are no additional tax benefits for holding an IRA plan within an annuity product. You should select an annuity product for its other benefits and features.

Inheriting an annuity can come with a unique set of tax implications, depending on the type of annuity and the beneficiary's relationship to the original owner.

If a spouse inherits an annuity (qualified or nonqualified), they typically can treat the annuity contract as their own. This means they continue to enjoy the tax deferral and only pay taxes on withdrawals, just as their spouse did.

Non-spousal heirs, such as children or grandchildren, can take a lump-sum distribution, which would be fully taxable. Another option is to continue tax-deferred growth by spreading distributions out over a number of years. The time frame will depend on whether or not the annuity is qualified or non-qualified, spreading out the tax liability.

Variable annuities, fixed annuities, and fixed indexed annuities all benefit from tax-deferred growth.

The taxable portion depends on how you made your initial investment and how you take withdrawals. If it's a qualified annuity, the money you invested was pre-tax, and 100% of your withdrawals will be taxable. However, if your annuity is nonqualified, you invested using after-tax dollars and pay taxes on the earnings portion of withdrawals. You'd then receive the principal tax-free.

Avoiding paying taxes on an annuity is generally unlikely. Still, there are strategies you can use to minimize the impact, such as taking withdrawals in a series of payments over several years instead of a lump sum—thus spreading out the taxes due—or investing in tax-free annuities in a Roth IRA, which has additional plan requirements.

A financial advisor and a tax professional can help you understand your annuity's tax consequences. To learn more about the types of annuities available and how they can help you reach your retirement goals, connect with a Thrivent financial advisor near you.