Understanding the Tax Implications of Annuities

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Taxes on annuities are both complicated and most of all, unavoidable. Tax obligations are typically met in one of two ways. (1) If you purchase an annuity with pre-tax money from a 401(k) or an IRA, for example, it is considered a qualified annuity and your payments from it will be taxed as income. (2) If you purchase an annuity with after-tax money it is considered a non-qualified annuity and you will pay taxes on the annuity’s earnings. 

The tax benefit: Although not tax-free, annuities are tax deferred. This makes it possible for investments to grow tax-free until you withdraw funds. 

One catch: If the annuity is purchased with a Roth IRA or Roth 401(k), it can be completely tax free pending specific requirements. 

The Exclusion Ratio: For non-qualified annuities, the exclusion ratio considers the original purchase of the annuity, the length of time the annuity has existed, the interest the annuity has earned, and the account’s assigned life expectancy to determine the amount of taxes to be paid. 

More annuity tax tips: 

If you withdraw funds before you turn 59 ½, you may be subject to a 10 percent penalty on the taxable portion of the withdrawal. 

Withdrawing as a lump sum after you reach 59 ½ may also trigger an earnings tax. 

For monthly income payments from a non-qualified plan, the return of your net cost for purchasing the annuity is tax-free, and the remainder is considered the earnings or the taxable balance. Similar rules apply for inherited annuities. 

The bottom line: A major benefit of annuities is that they allow your money to grow tax-deferred, leaving you, in theory, with more money later on. But again, annuities are tax-deferred, not tax free. Whether you pay upon purchase using taxed funds, or pay with tax-free funds, the IRS ensures that you pay the proper amount. That said, choosing to invest in a qualified or non-qualified annuity should be in line with your tax strategy and long-term financial goals

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