Annuity payments are subject to tax based on how the annuity was funded. If your annuity was funded with pre-tax dollars, typically seen in qualified plans, the entire amount of the withdrawals or payments you receive is taxable as income. Conversely, if your annuity was purchased with post-tax dollars, as with nonqualified plans, you are only taxed on the earnings portion of the withdrawals.
Jennifer Schell, CAS® Financial Writer, Certified Annuity Specialist® Jennifer Schell is a professional writer focused on demystifying annuities and other financial topics including banking, financial advising and insurance. She is proud to be a member of the National Association for Fixed Annuities (NAFA) as well as the National Association of Insurance and Financial Advisors (NAIFA). Read More
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John Stevenson, CFF Owner and Advisor at Stevenson Retirement Solutions John Stevenson, a Certified Financial Fiduciary®️, specializes in securing retirements with tax-free accounts. With a focus on guaranteed retirement, he's ensured none of his clients suffer from market fluctuations. As a renowned educator and podcast host, John empowers thousands weekly, sharing his expertise in minimizing taxes and protecting against financial downturns. Read More
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One of the biggest benefits of annuities is their ability to grow on a tax-deferred basis. This includes dividends, interest and capital gains, all of which may be fully reinvested while they remain in the annuity.
Your investment grows without being reduced by tax payments, but that doesn’t mean annuities are a way to avoid taxes completely. Annuities are subject to taxation, and how they are taxed depends on various factors.
“When you take distributions or withdraw from the annuity later in retirement, you will be taxed on the growth at your then-current tax rate,” explained annuity and retirement expert Paul Tyler.
Because of the complexity, it’s best to consult with a tax professional when purchasing an annuity and before withdrawing any funds.
John Stevenson, CFF Owner and Advisor at Stevenson Retirement SolutionsA popular strategy for generating tax-free income from an annuity is through a Roth Conversion. My clients frequently buy an annuity within a traditional IRA and subsequently opt to convert it to a Roth before initiating their income stream. This approach enables them to capitalize on the contractual guarantees without incurring a lifetime of taxes on their annuity income.
John Stevenson, a Certified Financial Fiduciary®️, specializes in securing retirements with tax-free accounts. With a focus on guaranteed retirement, he’s ensured none of his clients suffer from market fluctuations. As a renowned educator and podcast host, John empowers thousands weekly, sharing his expertise in minimizing taxes and protecting against financial downturns.
The tax treatment of an annuity is determined by the type of annuity, the source of funds — meaning whether it is held in a qualified or non-qualified account — and the purpose of the annuity.
Annuities are classified as either qualified or non-qualified.
Qualified annuities are funded with pre-tax dollars, typically through an employer-sponsored retirement plan like a 401(k) or an IRA. Contributions to these annuities are tax-deferred, meaning taxes are paid when withdrawals are made.
Non-qualified annuities, on the other hand, are funded with after-tax dollars. As such, they require tax payments only on the earnings portion at withdrawal.
The exclusion ratio is used to determine what percentage of non-qualified annuity income is taxable. Essentially, this entails segregating the annuity payments into a principal component (not taxable) and an earnings component (taxable).
Did You Know?The exclusion ratio takes into account the principal that was used to purchase the annuity, the amount of time the annuity has been paying, the interest earnings and the annuitant’s life expectancy.
If an annuitant lives longer than his or her actuarial life expectancy, any annuity payments received after that age are fully taxable. That’s because the exclusion ratio is calculated to spread principal withdrawals over the annuitant’s life expectancy. Once all the principal has been accounted for, any remaining income payments or withdrawals are considered to be from earnings.
Exclusion Ratio Example
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Get the most accurate estimate with our calculator’s real-time annuity product data.How and when you withdraw funds from your annuity also affects your tax bill.
In general, if you withdraw money from your annuity before you turn 59 ½, you may owe a 10% penalty on the taxable portion of the withdrawal.
After that age, taking your withdrawal as a lump sum rather than an income stream will trigger the tax on your earnings. You’ll have to pay income taxes that year on the entire taxable portion of the funds.
Did You Know?Withdrawals and lump-sum distributions from annuities are taxed as ordinary income. They do not receive the benefit of being taxed as capital gains.
Regardless of how you withdraw the money, the tax status of the contract determines how much of the withdrawal will be taxed. If it’s a qualified annuity, you will pay taxes on the full withdrawal amount. If it is non-qualified, you will pay income taxes on the earnings only.
Non-qualified annuity withdrawals use last-in-first-out (LIFO) tax rules, which dictate that earnings are taxed first. Consequently, tax liability tends to be higher in the early years of annuity ownership. Once the amount withdrawn exceeds the amount of earnings, subsequent withdrawal amounts are considered a tax-exempt return on your principal.
For example, if you invested $100,000 in an annuity that grew to $150,000, your gains would be $50,000. If you then began making withdrawals from that annuity after age 59 ½, all withdrawn funds up to $50,000 would be subject to income tax.
Since it would be considered a return on your principal, you wouldn’t have to pay taxes on any amount withdrawn after that $50,000.
According to the General Rule for Pensions and Annuities by the IRS, each annuity income payment from a non-qualified plan is made up of two parts. The tax-free part is considered the return of your net cost for purchasing the annuity. The rest is the taxable balance or the earnings.
When you receive income payments from your annuity as opposed to withdrawals, the idea is to divide the principal amount — and its tax exclusions — evenly out over the expected number of payments. The rest of the amount in each payment is considered earnings subject to income taxes.
