Annuities and Taxes – What You need to Know

If you’ve ever considered ways to build retirement income you’ve probably come across annuities. Let’s break it down. This guide will explain:

What annuities are (in plain English).

The types of annuities.

• How annuities are taxed depending on the source of the money.
• And how to avoid the most common tax traps.010010 An annuity is a savings account designed to pay out regular payments during retirement. But unlike a typical savings account, annuities can offer tax-deferred growth and structured income payments, which can be a big help when you’re trying to stretch your retirement savings.
• How do annuities work: the basics
• There are two main phases to an annuity:

Accumulation phase

: You fund the annuity either with a one-time lump sum or ongoing contributions. Your money grows tax-deferred.

Annuitization (payout) phase

: You start receiving periodic payments from the annuity. These can last a set number of years or continue for life.

Different types of annuities

1. There are a lot of ways to slice and dice annuities, but here are the main categories that matter:Immediate vs. deferred annuities
2. Immediate annuity: You start getting paid almost right away (usually within a year). These are ideal if you’re already retired and want to turn a large lump sum of money into monthly income.

Tax-deferred annuity

: Payments start later — maybe years or even decades down the line once you reach a specified age. In the meantime, your money grows tax-deferred.

Fixed, variable, and indexed annuities

• Fixed annuity: These pay a guaranteed minimum interest rate.
• Variable annuity: This type of annuity lets you invest in funds similar to mutual funds. Returns (and future annuity payments) can go up or down depending on the market.

Indexed annuity

• : These are fixed annuities tied to a stock market index like the S&P 500.Qualified vs. non-qualified annuities
• Here’s where it starts to matter for your taxes: annuities come in two basic categories — qualified and non-qualified. The IRS has different tax implications for each of these annuities. What is a qualified retirement account? (tax-sheltered account)An annuity funded with pre-tax funds is usually done through a retirement plan such as a traditional IRA, 401(k), or 403(b). Since the money hasn’t yet been taxed, any withdrawals you make will be treated as ordinary income. (after-tax contributions)
• On the other hand, a non-qualified annuity is funded with after-tax dollars — meaning the money has already been taxed before it goes into the annuity. The growth (the earnings) is taxed when you withdraw. Let’s break it down by situation. Let’s break it down by situation.Qualified annuity taxation

Since these are funded with pre-tax money, everything that comes out is taxed as ordinary income, just like IRA or 401(k) distributions.

You don’t pay taxes while the money grows (thanks to tax deferral).

But you will pay income tax on the full amount when you start receiving annuity payments.

Required minimum distributions

If your annuity is inside a qualified plan like a traditional IRA or 403(b), this means required minimum distributions (RMDs) apply once you hit age 73 (or 70 1/2 for those born before July 1, 1949). If you don’t take the required amount from your annuity, the IRS could hit you with a hefty 25% tax penalty.

Confused about RMDs? Check out the IRS required minimum distribution FAQ page.

Example

You put $100,000 into a tax-sheltered annuity through your employer’s 403(b) plan. That’s pre-tax money, so when you retire and start getting annuity payments, every penny you receive is subject to income tax.

Non-qualified annuity taxation

Non-qualified annuities are a little more nuanced.

• Your after-tax contributions come back to you tax-free.
• Only the earnings are taxed as ordinary income.

You don’t owe capital gains tax on your earnings because annuities are taxed differently than stocks or mutual funds.

Example

You buy an annuity with $50,000 from your savings. Only the earnings are taxed as ordinary income. The $50,000 in after-tax money is returned to you tax-free. The IRS uses the exclusion rate to determine how much each non-qualified payment is taxed. Basically, it’s a formula that spreads your after-tax dollars evenly across your expected life expectancy.

Exclusion ratio formula:

Original after-tax investment / Total expected payments

Remember: non-qualified annuities are funded with after-tax dollars, so you won’t be taxed again on the money you already paid taxes on.

But the earnings — meaning the amount your investment grew — are taxable.

• The exclusion ratio spreads your after-tax contributions evenly over your expected life expectancy, so each payment is partially tax-free and partially taxable until you’ve recovered your original investment.
• Exclusion ratio example
• Let’s say you buy a non-qualified annuity with a lump sum payment of $120,000 using after-tax money from your savings account.

The insurance company tells you it will pay you $800 per month for the rest of your life, starting at age 65.

Based on your age, the insurance company assumes your life expectancy is 25 years (or 300 months).

Step 1: Determine the total expected return.

$800 per month x 300 months = $240,000 total expected annuity payments over your lifetime.

Step 2: Calculate the exclusion ratio.Original after-tax investment / Total expected payments
$120,000 / $240,000 = 0.50 or 50%

• This means 50% of each monthly payment is tax-free and considered a return of your own money. The other 50% is taxable.
• Step 3: Break down each monthly payment

.

Tax-free portion: $800 x 50% = $400

Taxable portion: $800 x 50% = $400 (taxed as ordinary income)

• So, each year, you’d receive:
• $4,800 in tax-free income

$4,800 in taxable income

What happens if you live longer than expected?

Once you’ve recovered your entire after-tax contribution (the full $120,000), all future annuity payments become fully taxable. In the example above, any annuity payments after the 300-month mark are fully taxable. That’s because you’ve already received all your after-tax money back, so now every dollar is coming from earnings.

What if you pass away early?

If you die before recovering your full after-tax investment, the remaining unrecovered amount may pass to your beneficiaries, depending on the terms of your annuity contract. You won’t have to pay tax twice on money you already paid. Similarly, a cash refund annuity ensures that if you (the annuitant) die before getting the full value out of your investment, the remaining amount gets refunded to your beneficiaries.

Early withdrawals and tax penaltiesIf you take money out of your annuity before age 59 1/2, the IRS might hit you with a 10% additional tax on top of your regular tax rate — unless you qualify for an exception. Exceptions may be given for certain situations like a hardship withdrawal.

• You may also face surrender charges from the life insurance company if you cash out too soon. This IRS form reports distributions from pensions, annuities, retirement or profit-sharing plans, IRAs, and insurance contracts. This IRS form reports distributions from pensions, annuities, retirement or profit-sharing plans, IRAs, and insurance contracts.
• Other forms you might see include:

Form W-4P

• : When you first set up your annuity payout, you’ll often fill out a W-4P to choose how much federal income tax should be withheld from each payment.
• Form 5498

: If your annuity is held in an IRA (especially a traditional IRA), this form shows annual contributions and rollovers — but it’s usually for informational purposes and doesn’t need to be filed with your return.

State 1099 equivalents

: Some states have their own versions of 1099 forms if you live in a state that taxes retirement income.

Smart tax strategies for annuities

Annuities can be powerful retirement tools, but without a little planning, you might end up handing more to the IRS than necessary. The good news is that you can manage the tax implications and make the most of your retirement income by using a few strategies. Here are some strategies you should consider:

1. Time your withdrawals strategically.

If you’re not required to take money out yet (as with a deferred annuity), holding off could mean lower taxes down the line — especially if you’ll be in a lower tax bracket after retiring.

Retiring early? You may have a period where your income is low but you are not required to take RMDs or collect Social Security. Consider spreading out withdrawals with periodic payments over several years instead of taking lump sums. Use non-qualified annuities to supplement tax-free or low-tax income.

Non-qualified annuities (funded with after-tax money) give you a built-in tax deferral and only tax you on the earnings portion. This makes them a smart way to layer in income between other tax-free sources like a Roth IRA.

By mixing income types, you can have more control over your taxable income in retirement.

3. RMDs are important. Once you reach RMD age, your first RMD must be taken by April 1 the following year. IRS can slap you with a 25% penalty (it was 50% before!). Consider starting annuity payments to satisfy your RMD to avoid surprises. Coordinate with Social Security income.

• Because annuity payments count as ordinary income, they could cause more of your Social Security benefits to be taxed — up to 85% of those benefits, depending on your income level.A little coordination here can go a long way. A tax advisor or financial advisor can assist you in determining the best time to withdraw from your retirement accounts, Social Security, and annuities.
• 5. Avoid early withdrawal penaltiesTaking money out of an annuity before age 59 1/2 can trigger a 10% early withdrawal additional tax unless you qualify for an exception (like disability or certain medical expenses).
• Also, watch for surrender charges, especially in the early years of an annuity contract. These can significantly reduce the amount you actually take home.Annuity tax FAQs

What is a tax-sheltered annuity?

Employers like schools, hospitals, or nonprofits typically offer a tax-sheltered annuity. It is funded with pre-tax dollars through a qualified plan, such as a 403(b). Tax-deferred earnings grow tax-deferred. You don’t pay tax until you begin taking distributions. This can be applied to both qualified and unqualified annuities. However, in non-qualified annuities, only the earnings are taxable when withdrawn.

How are annuities taxed when you die?

If you pass away with money left in your annuity, your beneficiaries may inherit the annuity contract. The beneficiaries will usually owe income taxes on the taxable portion, but not necessarily a penalty for early withdrawal. Annuities are included in Social Security taxes. Annuity income is included in the IRS’s calculation of how much of your Social Security will be taxed. Should I choose a Roth IRA for retirement or an annuity?

A Roth IRA can grow tax-free and qualified withdrawals can also be tax-free. This makes it more flexible than annuities. Annuities provide guaranteed payouts throughout your life, which is something that some people value over tax efficiency. It all depends on the retirement plan you have and your financial goals. Annuity withdrawals do not receive capital gains tax rates, but are taxed at ordinary income rates. How do I calculate the tax rate on my annuity payments? The IRS exclusion ratio, which we discussed earlier, helps determine how much of each payment is taxable. For qualified annuities the entire payment is usually taxable. Can I rollover an annuity and not pay taxes? For more information, please refer to IRS Publication 575. Can I deduct my annuity contribution from my taxes?

• Yes. But only qualified annuity payments are tax-deductible because they are made using pre-tax dollars. If you use after-tax dollars, you don’t get a deduction — but you also won’t be taxed again on your contributions when you start taking money out.
• Do I owe state taxes on my annuity payments?

Each state treats annuity income differently, so be sure to check with your state tax agency or a tax professional for guidance. The bottom line

Annuity rules can be complicated, but they don’t have to. Understanding the tax treatment up front can save you from unpleasant surprises later on.

Story originally seen here