Annuities are a popular retirement planning tool, offering guaranteed income and tax-deferred growth. But understanding how annuities are taxed is crucial for your retirement income strategy. This guide breaks down key annuity tax rules, when you owe taxes, and what to watch out for with the IRS.
What Is an Annuity?
An annuity is a contract between you and an insurance company. In exchange for a lump sum or a series of payments, the insurer promises regular income—often for life. There are fixed, variable, and indexed annuities, each with unique features and tax considerations.
Annuity Taxation Basics
The main tax advantage of annuities is tax-deferred growth. You won’t pay taxes on earnings until you withdraw money or begin receiving payments. Taxation depends on:
- Type of annuity (Qualified vs. Non-Qualified)
- How you funded the annuity
- When you take distributions
Qualified vs. Non-Qualified Annuities
Qualified Annuities
Purchased with pre-tax dollars, usually through IRAs or 401(k)s. All withdrawals are fully taxable as ordinary income.
Non-Qualified Annuities
Funded with after-tax dollars. Only the earnings portion of withdrawals is taxable; your original contributions are not taxed again.
How Are Annuity Withdrawals Taxed?
Non-Qualified Annuities
Withdrawals follow the “last in, first out” (LIFO) rule: earnings come out first and are taxed as ordinary income. Once all earnings are withdrawn, the principal is tax-free.
Qualified Annuities
All withdrawals are taxed as ordinary income, since they are funded with pre-tax dollars.
Taxation During the Payout Phase
When you annuitize and start receiving payments, each payment is split between taxable earnings and non-taxable return of principal (for non-qualified annuities). The insurance company calculates an “exclusion ratio” to determine the taxable portion.
Early Withdrawal Penalties
If you withdraw funds before age 59½, you may face a 10% early withdrawal penalty on the taxable portion, plus regular income taxes. Some exceptions apply, such as disability or certain qualified plans.
Required Minimum Distributions (RMDs)
For qualified annuities in IRAs or retirement accounts, you must start taking RMDs at age 73. Failing to take RMDs can result in significant tax penalties.
Taxation at Death: Beneficiary Considerations
Beneficiaries may owe taxes on untaxed earnings. Lump-sum payouts are generally fully taxable on the earnings, while installment payments may be partially taxable, depending on the exclusion ratio.
Key Takeaways
- Tax-Deferred Growth: Annuities grow tax-deferred until you take withdrawals.
- Earnings Are Taxed as Ordinary Income: Both qualified and non-qualified annuity earnings are taxed at your regular income tax rate.
- Principal May Be Tax-Free: For non-qualified annuities, your original investment is not taxed again.
- Early Withdrawals May Trigger Penalties: Avoid taking money out before age 59½ unless you qualify for an exception.
- RMDs Apply to Qualified Annuities: Be aware of required minimum distribution rules if your annuity is in a retirement account.
Frequently Asked Questions About Annuity Taxation
Are annuity payments taxed as ordinary income or capital gains?
Annuity payments are typically taxed as ordinary income, not capital gains. The portion representing earnings is taxed at your regular income rate, while the return of your original investment is not taxed for non-qualified annuities.
When do I have to pay taxes on my annuity?
You pay taxes on annuity earnings when you withdraw funds or begin receiving payments. Until then, your annuity grows tax-deferred.
Do I pay taxes on my initial investment in a non-qualified annuity?
No, you do not pay taxes again on your initial investment in a non-qualified annuity. Only the earnings portion of withdrawals is taxable.
What happens if I take money out of my annuity before age 59½?
If you withdraw funds before age 59½, you may owe a 10% early withdrawal penalty on the taxable portion, plus regular income taxes, unless you qualify for an exception.
How are annuities taxed when passed on to beneficiaries?
Beneficiaries generally pay income tax on the earnings portion of inherited annuities. Lump-sum payouts are fully taxable on the earnings, while installment payments may be partially taxable depending on the exclusion ratio.
Test Your Annuity Tax Knowledge!
Want to see how much you know? Use our interactive quiz below or contact us for a personal review.
