Taxes Involved In Owning An Annuity

Estimating taxes for annuity payments can be confusing, but by using general principles, based on the type of annuity and payout option, you can predict what you will owe before tax season starts.

Are you concerned about the tax implications of having the rights to future annuity payments or receiving them now? When it comes to preparing for retirement, future retirees see extra taxes as a major determinant in choosing the makeup of their investment portfolios and savings plans.

Annuities generate tax-deferred growth – usually over a long period of time. Usually, taxes come due only after the investment starts to pay off, either over time or in a lump sum. The actual tax rate depends on a variety of factors, including the type of annuities and the payout option. Not surprisingly, estimating today the taxes you will pay years from now gets complicated.

Your tax base today also depends on how you bought your annuity, the earnings off if it and when you receive payments.

Your Type of Annuity Determines Your Tax Liability

The biggest factor for how much you’ll owe the Internal Revenue Service (IRS) is the type of annuity you choose. Annuity issuers provide options for saving as much money as possible now to protect your future.

Investors who don’t need this income for many years often prefer deferred or variable annuities. Those who need a faster turnaround typically pick from a set of fixed-payment options that start immediately.

Deferred Annuities

Deferred annuities delay taxes. You don’t collect your payments right away, and you won’t pay taxes right way. These annuities perform in two phases: accumulation and distribution.

Accumulation: During this tax-free phase, the person who owns the annuity (known as the annuitant) makes payments into the account. All money in the account earns interest.

Distribution: Payments get distributed to owners from their account(s). Payments come in a lump sum or a series of smaller payments based on a set term or lifespan. Owners pay income taxes on the money they receive and not on any of the underlying funds.

If you pay into an account during the first years of owning the annuity, you’ll pay taxes when the issuer distributes payments. This means the IRS does not exempt you from taxes, but allows you to grow your investment and pay the income tax as you receive your money.

Fixed Annuities

If you opt for fixed payments, you owe taxes on the earned portion of the every distributed payment. This works out to a small amount every month or year (based on the timing of when the annuity pays out). Because your total annuity is divided into payments, the issuer assigns an exclusion ratio to figure out your annual taxes. An exclusion ratio calculates your taxable income based on the annuity principal, your life expectancy and your estimated total earnings.

For example:

  • An annuity owner begins with a principal of $150,000. Once the owner turns 62, the investment pays $1,000 a month for as long as the owner lives.
  • The IRS, using its life-expectancy table, calculates that payments would continue for 22.5 years.
  • It would value the contract at $270,000 (12 months a year x 22.5 years x $1,000 a month).
  • The ratio would be determined by dividing $150,000 by $270,000 – or 55.6 percent.
  • Of the $12,000 a year in income, $6,600 would be excluded from income tax.

Check out IRS Publication 939, General Rule for Pensions and Annuities, for a more in-depth explanation.

Variable Annuities

The value of variable annuity payments changes with stock market fluctuations, making it impossible to pinpoint exact taxes. That said, you can determine the amount excluded from taxes.

Using the same annuity figures from the previous example:

  • The principal is $150,000, and payouts begin at age 62.
  • Divide the principal by the amount of payments, which is 270 (12 months X 22.5 years) and get a total of $555.55 ($150,000/270).
  • You will only pay taxes for the amount you receive in excess of $555.55.

Qualified Annuities

If you used pre-tax dollars from retirement accounts – from an Individual Retirement Account (RA) or 401(k), two name two – to purchase an annuity, you own a qualified annuity. For these accounts, you pay taxes on the entirety of distributions.

Non-Qualified Annuities

For non-qualified annuities (purchased with after-tax dollars), the IRS calculates taxes based on the type of annuity payout.

Your Annuity Payout Impacts Tax Total

Once you take in the impact of timing as it relates to your tax liability, you can evaluate the amount you owe based on how the annuity issuer distributes your payout. Payout options include lump sums and a stream of payments. You can also access the money early through withdrawals or selling payments.

Lump Sum Payments

If you opt for a one-time payout, you’ll pay taxes on the difference between the total amount you invested and the amount the investment earns. For a $150,000 investment that pays $250,000, you owe taxes on the $100,000 profit. The IRS sees this as pure income.

Periodic Payments

The IRS uses its exclusion ratio (as explained above) to calculate taxes on a stream of payments. It’s up to you and your annuity issuer to determine the size and frequency of payments. You can estimate your income tax by applying the exclusion ratio to the total sum of payments you receive per year.

Withdrawals

When you take withdrawal money from your annuity (outside of money that distributed), you pay taxes based on the date of the annuity purchase. The IRS views any income from annuity investments bought after Aug. 13, 1982 as part of your earnings. In those cases, you would pay tax on that income.

Also, if you are younger than 59 ½, you’re subject to a 10-percent early withdrawal penalty. You’ll owe taxes until the amount you withdraw equals the principal you invested.

Selling Annuity Payments

If you sell all or part of your future payments for immediate cash, you’ll owe taxes on the money you gain. If you are under age 59 ½, you’ll also owe a 10-percent early withdrawal penalty. But because you won’t receive these payments during retirement, your future taxes liability will be decreased.

Page Sources

  1. Internal Revenue Service. (Dec 2013). General Rule for Pensions and Annuities. Retrieved from http://www.irs.gov/pub/irs-pdf/p939.pdf
  2. Lankford, K. (2009, July 10). How annuities are taxed. Kiplinger.com Retrieved from http://www.kiplinger.com/article/insurance/T003-C001-S001-how-annuities-are-taxed.html
  3. Edward Jones. (2014, October 24). Annuity Taxation. Retrieved from https://www.edwardjones.com/en_US/products/investments/annuities/annuities_tax/index.html
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