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
The accumulation & distribution phases of an annuity
After you purchase an
It's important to note that only
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.
How are qualified annuities taxed?
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.
How are nonqualified annuities taxed?
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.
An example of taxes on an immediate nonqualified annuity
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.
How early withdrawals from a deferred nonqualified annuity are taxed
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.
Are you considering an annuity?
How are different types of annuities taxed?
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.
Annuities inside an IRA are taxed as other IRA investments
When you put money into an
Taxes on inherited annuities depend on the beneficiary's relationship
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, fixed & fixed indexed annuities
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.
Minimizing the impact of annuity taxation
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