Annuity Taxation

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Annuity Taxation
Tax. Benjamin Franklin looking calculator on One Hundred Dollar Bill.

Like most people, you may know that one of the main features of an annuity is that it’s tax-deferred. Annuities can an excellent way to help lower the amount of income tax owed on various investments while saving money for your retirement.

However, remember that Uncle Sam will still be entitled to tax a specific portion of payments received or funds withdrawn. These funds include dividends from stock investments, interest on bank accounts, and capital gains. You can fully reinvest them while they remain in the annuity, which is excellent. This is beneficial as it allows your investment to increase without being lowered by tax payments.

Did you know that an annuity can provide you with guaranteed income for as long as you live? As a retirement savings vehicle, they provide some tax benefits by letting your earnings grow tax-deferred.

Also, annuity income can play a crucial role in retirement planning. If used correctly, it will provide a steady and stable income stream for the rest of the annuitant’s life. It is prudent and intelligent to formulate a plan to deal with these future taxes effectively.

Annuities are usually purchased with after-tax money. So, if you buy an annuity with after-tax dollars, this feature will save your initial investment from any tax deductions, and you’re required to pay taxes just on the earnings.

On the other hand, if you buy an annuity with pre-tax funds, payments, such as dividends, from the annuity are fully taxable as income. Annuities offer you tax-deferred growth, and taxes on annuities are not due until a person withdraws money from the annuity.

However, keep in mind that many regulations and rules impact how and when annuity funds are subject to taxation. So, it is best to consult an experienced tax professional when you set up an annuity to be completely aware of the various potential tax implications.

Are Annuities Tax-Free?

Annuities are not tax-free, rather they are tax-deferred. What does this mean? It means that you do not have to pay income taxes on the funds while they grow. Rather, you will have to pay taxes later on when you receive the payments.

Taxes are not owed until the annuitant receives income payments from the annuity. However, it is worth noting that these annuity withdrawals and distributions are not taxed as capital gains but instead as ordinary income.

And this means that your tax rate will depend on the amount of income you earned and the tax bracket that you fall into the year that you receive the funds. It is a good chance that you are retired when the withdrawals take place, and thus, you will fall into a lower tax bracket, which will enable you to pay relatively lower tax on withdrawals.

How Annuities Are Taxed

Annuity taxation is not that straightforward, one-for-all process. You should keep in mind that how any specific annuity is taxed depends on the source of funds used. So, if you used your pre-tax funds to fund your initial deposit, it is a qualified annuity.

On the other hand, if you set up the annuity with funds you already paid income taxes on, it is a non-qualified annuity. For instance, if you use money from a Roth 401(k) or a Roth IRA (individual retirement account), you may be able to escape federal income taxes.

So, whether you have a non-qualified annuity or qualified annuity is key to determining how the annuity is taxed.

How are Qualified Annuities Taxed?

A qualified annuity is one that is funded using your pre-tax funds (money you’ve yet to pay income taxes on). For example, a qualified annuity would be if the premiums to fund an annuity came from any tax-deferred retirement account like a traditional IRA or traditional 401(k).

Note that once the funds are in the account, they continue to grow tax-deferred. So, both the principal amount and the earnings on the annuity haven’t been taxed yet. Finally, the annuity will enter the important payout phase, and you will receive the money (either as a lump sum or in periodic payments).

When this happens, you’ll have to pay taxes on the distributions. When payments come from any qualified annuity,  the funds it is taxable income as that money wasn’t previously taxed.

How are Non-Qualified Annuities Taxed?

We can define a non-qualified annuity as the one you purchase with funds you’ve already paid federal taxes on. If you wrote a check from your taxable brokerage account or bank account to pay the annuity premium, it is a non-qualified annuity.

Non-qualified annuities work a little differently. Also, it is helpful to think about a non-qualified annuity as comprising two parts:

  • The earnings (annuity increase or growth from dividends, interest, or capital gains)
  • The principal (the amount you funded with your after-tax dollars)

As you have already paid income taxes on the principal, you won’t be taxed again. However, keep in mind that you have yet to pay taxes on the earnings. As a result, when you receive distributions, you’ll pay taxes on any gains.

Exclusion Ratio

It is worth mentioning that there’s a calculation known as the “exclusion ratio” that determines which percentage of the annuity income, such as 20%, is subject to tax and the percentage that is not. It tells you the portion of the annuity payment that comes from your after-tax funds.

The exclusion ratio considers the funds you used to open the annuity.  It also takes into account the period your annuity has been active, as well as the interest earnings. Also, note that if an annuitant outlives their life expectance, all payments made from the annuity after the age (determined using annuity tables) are deemed taxable. 

Annuity Withdrawal Taxation

There is no doubt that an annuity is a brilliant addition to your overall retirement plan. However, it’s important to note that you will have to pay early withdrawal penalties on the annuity if you withdraw before the designated time period. Overall, if you withdraw money from your annuity before age 59 ½, you will likely have to pay a 10% penalty on the taxable part of the funds. 

However, after the age of 59 ½, if you make a lump-sum withdrawal, you will only need to pay tax on the taxable portion of your withdrawal. Also, it is worth noting that if you are permanently disabled at the withdrawal date, Uncle Sam will waive this penalty. 

However, if funds remain in your annuity, the IRS will likely classify the initial and all subsequent withdrawals as interest. As a result, they will be taxable.

Annuity Payouts – Tax Implications 

In most cases, monthly income payments from your non-qualified annuity consist of two portions:

  1. There is a tax-free portion, which is deemed as repayment of your net cost of the annuity; and
  2. The remaining portion of the payment that’s taxable as earnings

Keep in mind that when you get income payments, such as dividends from your annuity, rather than withdrawals, the main idea is to split the principal amount as well as its tax exclusions evenly over the expected total number of payments. And the remaining amount in each payment is deemed earnings subject to taxes.

Taxes on Inherited Annuities

It is no secret that inheriting an annuity can provide you with an unexpected and valuable financial windfall; however, you have to consider specific tax implications. On the other hand, what about if you pass away and your beneficiary inherits the annuity you funded? Will they need to pay taxes on an inherited annuity?

You will be glad to know that the rules for a beneficiary, such as your child or wife, are the same as the rules for you, the policyholder. If it is a qualified annuity, they will have to pay taxes on the whole distribution. 

On the other hand, if it is a non-qualified annuity, the earnings will be taxed, but the principal is not subject to taxes. Again, remember that annuity withdrawals are taxed at the standard income tax rate, not capital gains. 

Annuity Taxation – FAQs

Do I have to Pay Taxes on Annuities?

You will have to pay income taxes on the annuity after you withdraw the funds or start receiving payments. When you make a withdrawal, the funds will be taxed as income if you bought the annuity with your pre-tax dollars. On the other hand, you would only pay taxes on the earnings if you purchased your annuity with post-tax funds. 

Are Beneficiaries Required to Pay Tax on Inherited Annuities?

Earnings from an inherited annuity are taxed. However, keep in mind that the taxed amount will depend on the payout structure and the beneficiary’s relationship with the annuity holder. Did you know that the annuity death benefit will help create a financial legacy? For instance, you could leave substantial money to your spouse to help fund their retirement.

Final Thoughts 

Annuities offer you a robust and reliable way to secure a guaranteed and stable income stream in retirement and to defer paying income taxes. How your annuity is taxed will depend mainly on the funds that you use for its principal deposit. Besides the source of funds, the type of annuity also matters for determining your taxes. For example, for an immediate annuity, the tax treatment is different than a deferred annuity.

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