Annuities are unique investment vehicles that offer tax-deferred growth. This means you don’t have to pay taxes on the money your annuity earns until you start receiving payouts. This feature allows your money to grow faster than in a taxable account, as you don’t have to pay taxes on the gains each year.
However, the way your annuity payouts are taxed can vary depending on several factors:
The type of annuity you have (qualified or non-qualified, fixed annuity, indexed annuity, or variable annuity) How you funded your annuity (with pre-tax or post-tax dollars) When you choose to take withdrawals or start receiving lifetime income payments
Annuity Taxation 101: Types Of Annuities
The taxation on our annuity depends on whether your annuity is a qualified annuity or a non-qualified annuity:
Qualified Annuities
Qualified annuities are funded with pre-tax dollars, typically through an employer-sponsored retirement plan such as a 401(k) or a traditional IRA. Contributions to these accounts are made before taxes are deducted from income, which means you don’t pay taxes on the money you contribute UNTIL you withdraw it.
When you withdraw from a qualified annuity, the entire amount is taxed as ordinary income since you haven’t paid ANY taxes on the contributions or the earnings.
Non Qualified Annuities
Non-qualified annuities, on the other hand, are funded with after-tax dollars. This means you have already paid taxes on the money you use to purchase the annuity. When you withdraw from a non qualified annuity, only the earnings portion of the withdrawal is taxed as ordinary income.
The portion of the withdrawal representing your original contribution is NOT TAXED, as you have ALREADY paid taxes on that money.
Taxation of Annuity Withdrawals
Making withdrawals from your annuity can have significant tax implications, depending on your age and your type of annuity.
Withdrawal Before Age 59½
If you withdraw money from an annuity before you reach age 59½, you may usually face 10% early withdrawal penalty in addition to regular income taxes.
This penalty is meant to discourage people from using their retirement savings for non-retirement purposes. However, this rule has some exceptions, such as if you become disabled, have significant unreimbursed medical expenses, or use the money for qualified higher education expenses or a first-time home purchase (up to certain limits).
Withdrawal After Age 59½
Once you reach age 59½, you can withdraw money from your annuity without incurring the 10% early withdrawal penalty. However, you will still owe income tax on the taxable portion of your withdrawal. The tax treatment of your withdrawal depends on whether you have a qualified or non-qualified annuity, as explained earlier.
If you choose to receive your annuity payout as a lump sum, the entire taxable portion will be included in your income for that year, which could push you into a higher tax bracket. If you choose to receive your payout as an income stream, the taxable portion will be spread over time, which may help you stay in a lower tax bracket.
Taxation of Annuity Payouts: Are Annuities A Taxable Income?
The taxation of annuity payouts depends on your type of annuity and how you funded it.
Exclusion Ratio for Non-Qualified Annuities
When you receive payouts from a non-qualified annuity, each payment consists of two parts: a taxable portion (your earnings) and a non-taxable portion (your original investment). The exclusion ratio determines what percentage of each annuity payment is tax-free.
Here’s an example: Let’s say you purchased a non-qualified annuity for $100,000. Based on your life expectancy, the insurance company will pay you $1,000 per month for the next 20 years. The total payout over those 20 years is expected to be $240,000 ($1,000 x 12 months x 20 years). Your earnings are $140,000 ($240,000 – $100,000), and your original investment is $100,000.
To calculate the exclusion ratio, divide your original investment by the total expected payout: $100,000 / $240,000 = 0.4167. This means that 41.67% of each payout is considered a return of your original investment and is tax-free. The remaining 58.33% is taxable as ordinary income. If you live longer than your expected lifespan and continue receiving payments, those additional payments will be fully taxable.
Fully Taxable Payouts for Qualified Annuities
If you receive payouts from a qualified annuity, the entire amount is taxable as ordinary income. This is because you made your original contributions with pre-tax dollars and have yet to pay taxes on any of the money in the annuity.
Taxation of Inherited Annuities: How Are Inherited Annuities Taxed?
Inheriting an annuity can have significant tax implications, depending on your relationship with the original annuity owner and how you choose to receive the funds.
Spousal Beneficiaries
If you are the spouse of an annuity owner and inherit the annuity after their death, you can continue the annuity in your name. In this case, you would assume ownership of the annuity, and the tax treatment would remain the same as it was for your spouse. There are no tax penalties for spousal beneficiaries who choose to continue the annuity.
Non-Spousal Beneficiaries
If you inherit an annuity and are not the original owner’s spouse, you have several options for receiving the payout, each with its own tax implications.
Charitable Beneficiaries
If you name a charity as the beneficiary of your annuity, the annuity proceeds will pass tax-free to the charity upon your death. This can effectively offset the tax liability of other assets in your estate and support a cause you care about.
Additional Tax Considerations
Several other factors are also to consider when it comes to annuity taxation, such as 1035 exchanges and Qualified Longevity Annuity Contracts (QLACs).
1035 Exchanges for Non-Qualified Annuities
Section 1035 of the Internal Revenue Service allows you to exchange one non-qualified annuity for another without triggering a taxable event. This can be useful if you find an indexed annuity or variable annuity with better features, additional tax benefits, or higher payouts and want to switch without incurring a tax liability. However, it’s essential to work with a financial professional to ensure that the exchange is done correctly and that the new annuity is suitable for your needs.
Qualified Longevity Annuity Contracts (QLACs)
A Qualified Longevity Annuity Contract (QLAC) is a type of deferred income annuity that can be purchased within a qualified retirement plan, such as a 401(k) or an IRA. QLACs are designed to provide a guaranteed stream of income later in life, typically starting at age 80 or 85.
One of the main benefits of a QLAC is that it can help reduce your required minimum distributions (RMDs) from your qualified retirement accounts. The money you use to purchase a QLAC (up to certain limits) is excluded from the RMD calculation, which means you can keep more money in your retirement accounts for longer and potentially reduce your tax liability.
As of 2024, the maximum amount you can allocate to a QLAC is $200,000.
Strategies for Minimizing Annuity Taxation
If you expect to be in a lower tax bracket in retirement, a qualified annuity may be more beneficial, as you will pay taxes on the withdrawals at a lower rate. If you expect to be in a higher tax bracket in retirement, a non-qualified annuity may be more advantageous, as you will only pay taxes on the earnings portion of the withdrawals.
Timing of Withdrawals and Payouts
To minimize your tax liability, consider timing your annuity withdrawals and payouts strategically. For example, if you expect to be in a lower tax bracket in a particular year (perhaps due to a job loss or a significant deduction), you may want to take a larger withdrawal in that year to take advantage of the lower tax rate.
Annuitizing Deferred Annuities to Spread Tax Liability
If you have a deferred annuity, you can choose to annuitize the contract, which means converting it into a stream of guaranteed payments over a set period or for the rest of your life. By annuitizing, you spread the tax liability over the payout period, which may help you stay in a lower tax bracket and reduce your overall tax burden.
How To Report Annuity Income on Your Tax Return?
When you start receiving annuity payments, you must include this income on your annual tax filing.
The most important document you’ll receive when reporting annuity income is Form 1099-R. This form, issued by your annuity provider, summarizes the distributions you’ve received from your annuity during the previous tax year. It includes essential information such as the total amount distributed, the taxable portion of your distributions, and any federal income tax withheld.
You should receive your Form 1099-R by January 31st each year, covering the distributions from the prior year. If you have multiple annuities or receive distributions from various retirement income sources, you may receive multiple 1099-R forms. It’s important to keep all of these forms organized and to report each one accurately on your tax return.
IRS Publication 575: A Comprehensive Guide to Annuity Taxation
To help taxpayers navigate the complexities of annuity taxation, the Internal Revenue Service (IRS) publishes Publication 575, “Pension and Annuity Income.” This guide is updated annually and provides detailed information on how to report your annuity income on your federal tax return.
Publication 575 covers a wide range of topics related to annuity taxation, including:
You can access the most recent version of Publication 575 on the IRS website, ensuring that you have the most up-to-date information when filing your taxes.
Conclusion
In summary, the taxation of annuities depends on various factors, including the type of annuity (qualified or nonqualified annuity), the timing of withdrawals and payouts, and your individual financial situation.
However, you must take advice of a financial advisor and tax professional to develop a strategy that minimizes your tax liability and maximizes your retirement income.
FAQs
