Are Annuities Taxable?

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Are Annuities Taxable?

Are annuities taxable is a question we are often asked by our clients. Gain from an annuity is taxed as ordinary income but beyond that annuity taxation varies based on a number of variables. 

Annuities receive tax preferred treatment from the IRS because they are designed to be long-term retirement savings vehicles. Tax rules for annuities vary based on the type of annuity and how you ultimately take your money out.

In this are annuities taxable guide we will go explain how annuities are taxed based on the funds you use to purchase an annuity as well as how annuity income is taxed based on the each particular income option.

Annuities accumulate interest tax-deferred. Tax-deferral means you don’t pay taxes on the interest you earn until you take your money out. If you earn interest in a vehicle that doesn’t grow tax-deferred; such as a CD, you pay taxes on any interest you earn the year in which it is earned regardless if you take it out or not.

 

Are Annuities Taxable: Key Considerations

The deciding factor on how your annuity will ultimately taxed depends ultimately on the money you used to buy it. Whenever a client asks us how are annuities taxed, our first response is where did you get the money to buy it? 

Since we are talking about taxes there is no way to say with certainly exactly how your annuity will be taxed. Tax laws and tax rates can and do change all the time. 

However, we can make very educated guesses about certain scenarios based upon how annuities have been and are taxed currently. First we will look at the types of funds you can use to purchase an annuity and explain the differences in how they are taxed.

Are annuities taxable guide picture of scrabble tiles spelling taxes on top of tax return form

 

Qualified, Non-Qualified or Roth

Are annuities taxable if purchased with money from a Roth account?

If you purchase an annuity with funds from a Roth individual retirement account (IRA) or Roth 401(k) it is very likely you won’t have to pay federal income tax at all on the money when you withdraw it from your annuity. That includes the principal and interest.

 

Are Qualified Annuities Taxed?

Firstly, an annuity purchased with qualified funds is considered a qualified annuity. Qualified funds are monies that you have never paid taxes on such as a traditional IRA or a traditional 401(k). It would be nice if the IRS would allow to go from tax-deferred to tax-free but that is not the case.

When you begin to take withdraws from a qualified annuity you will pay normal federal income taxes. Meaning, 100% your annuity is treated as ordinary income and 100% of the funds will be taxed when they are taken. 

 

Are Non-Qualified Annuities taxed?

A non-qualified annuity is any annuity purchased with after tax-dollars such as money from a taxable personal savings or checking account or a personal brokerage account. 

If you own a non-qualified annuity, you will only pay income tax on the gain in your contract but not the money you used to purchase the annuity. The money used to purchase a non-qualified annuity is considered the “basis”. Insurance companies keep track of your “cost-basiswhich is the original amount used to purchase an investment. 

This “cost-basis” is the amount of money on which you will not pay taxes because you’ve already taxes on it once. The interest earned will be taxed as ordinary income, with a few exceptions that we will discuss momentarily.

 

Income Annuity Taxation

There are many different types of annuities including:
We are going to focus on income annuities here because all of the other above mentioned annuities are considered to be a deferred annuity, which we’ve just established are taxed depending on the types of funds used to purchase them.

 

There are really two types of income annuity payout options: lifetime or period certain. A lifetime annuity is an annuity that guarantees payments for as long as you are alive whereas a period certain annuity guarantees payments for a specified period of time. 

Remember, if you own a non-qualified annuity you only pay taxes on the interest earned not the original cost basis. So to determine what portion your monthly payments are taxable there is a calculation that needs to be done establish what percent of each annuity is principal (or cost-basis) and what percent is interest earned.

These calculations establish your exclusion ratio, or in plain terms, the percent of each annuity payment that is exempt from income taxes. The method of determining the exclusion ration varies depending on whether you have a period certain annuity or a lifetime annuity. Lets look at an example for each.

 

How is a Period Certain Annuity Taxed?

Let’s assume you purchased a 10 year period certain income annuity for $200,000 with non-qualified money that pays you $24,000 per year. In total you will receive $24,000 times for 10 years for a total of $240,000. You would be then liable for taxes on the $40,000 which is your expected return or the interest your will have earned.

Now you need to take the $40,000 and divide it by 120 which is the total number of monthly payments you will receive over the 10 year period. $40,000 divided by 120 equals $333.33. That is the amount of each monthly $2000 payment that will be taxed as income.

In this scenario the taxable portion of each payment ($333.33) is 13% of the total payment so your exclusion ratio is 87%. The 87%, in this case $1740,67, is the amount of each payment that will not be taxed.

 

How Are Lifetime Annuities Taxed?

How are annuities taxed when you will receive guaranteed payments for the rest of your life? First we must calculate your expected return. To do this, the IRS determines your life expectancy based on the social security life expectancy tables.

 

Let’s assume you purchase a lifetime income annuity at age 65 and based on the life expectancy tables you will live to be 85. The IRS will assume you will receive payments for 20 years when calculating your exclusion ratio. If you purchased a lifetime annuity for $200,000 that paid you 1,167 per month ($14,000 annually), for tax purposes it would be assumed you will receive a total of $280,000 ($14K X 20 years).

Then $80,000 of the $280,000 total payments will be taxable. Since you are expected to receive 240 monthly payments the amount of each payment that is taxed is again $333.33 ($80,000 divided by 240 equals $333.33). 

$333.33 of each $1,167 monthly payment would be taxable which equates to 28.6%. In this example, your exclusion ratio is 71.4% meaning 71.4%(or 833.67) of each monthly payment is excluded from taxes.

 

In Summary: How Are Annuities Taxed?

  • Withdraws from Roth Annuity- not taxable

  • Withdraws from non-qualified annuity – gains are taxed

  • Withdraws from qualified annuity – 100% taxed

  • Income annuities payments are taxed based on exclusion ratio

Are Annuities Taxable Key Tems

Cost Basis is Your initial payment/premium(s) paid to a nonqualified annuity is known as the cost basis in your contract. Since it was previously taxed, your cost basis will not be taxed upon withdrawal. If a previous distribution was not fully taxable, the cost basis would be reduced by the amount that was not taxable.

Source: Prudential.com

The exclusion ratio is a percentage with a dollar amount equal to the payback on an initial investment. Any return above the exclusion ratio is subject to taxes, such as a capital gains tax. Most of the time, the exclusion ratio applies to non-qualified annuities.

Source: Investopedia

An income annuity allows you to convert part of your retirement funds into a stream of guaranteed lifetime income payments using a single lump-sum of money called a “premium,” or through flexible premium payments over time, depending on the type of product selected.

Source: New York Life

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Kiara Caudill

Kiara Caudill

I spent the first 10 years of my career as a clinical mental health therapist and I saw firsthand that finances play a large role in one’s happiness. A good financial plan is not only important to your financial health it’s also important to your mental health. I approach financial planning from a behavioral finance perspective using a goals-based approach. Kiara holds a B.A. Degree in Psychology from Goshen College and an M.A. in Clinical Mental Health Counseling from Valparaiso University.

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We are financial planners based in Fishers, Indiana. We are annuity experts and specialize in helping pre-retirees (and those already enjoying it) make the transition from accumulation to distribution in retirement.

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