Your tax obligation when you sell your annuity payments is usually the same as it would be if you received regular payments or made a withdrawal from the annuity. To understand how that works, it’s helpful to review how annuities are taxed.
When it comes to the interest paid on a commercially-sponsored savings vehicle or investment instrument, the IRS is going to tax it. This holds true for the income distributed by a non-qualified annuity, which is a financial contract that has been purchased with after-tax dollars.
Thomas J. Brock, CFA®, CPAInvestment, Corporate Finance and Accounting ProfessionalThomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.
When Are Annuities Taxable?
The main tax benefit of most annuities is that they grow on a tax-deferred basis. That means the taxes are not paid until the funds are withdrawn or paid to you, which allows earnings to grow more quickly since they’re not taxed right away.
However, not all annuity funds are taxed equally. The main factor that determines how the money from an annuity is taxed is whether the funds that were used to purchase it have already been taxed. If the answer is yes, then the product is categorized as a nonqualified annuity. If the annuity is a structured settlement, such as a payout for injuries suffered in an accident, the proceeds are also not taxable in most cases.
With a nonqualified annuity, only the earnings are taxable. So when you receive money from a nonqualified annuity, you pay income taxes on any financial gains above the initial cost — the principal — of the annuity.
So, for example, let’s say you used money from your savings to purchase a $100,000 annuity. Over time, the value of the annuity grows to $120,000. In this case, since your savings come from your paycheck on which you’ve already paid income tax, the taxable portion of your annuity will be just $20,000.
The best way to determine how much of your money is taxable is to ask the insurance company that holds your annuity. It’s also wise to consult a tax advisor regarding your tax burden before selling your annuity, so you can understand all the potential tax consequences.
If you bought your annuity with pretax money from an IRA or a 401(k), you will have to pay income taxes on the portion of payments that have not already been taxed when you sell your payments. Any earnings on your annuity funds will be considered taxable as income. These are considered qualified annuities.
Certain types of annuities, such as those purchased as part of a pension plan or IRA, cannot be sold because the tax liability attached to the money can’t be transferred.
Interested in Selling Annuity or Structured Settlement Payments?
Taxes When You Sell
When you sell your annuity payments, they will be taxed the same as if you’d received a typical annuity withdrawal.
But annuities held in qualified retirement accounts typically can’t be sold to a third party. Such transactions make up the secondary market — similar to the stock market but specific to the sale of annuities.
If you sell your total nonqualified annuity contract, the amount in the annuity that exceeds what you paid for the annuity is considered taxable as ordinary income.
The money you may have spent on riders is not considered part of your initial investment and therefore is not excluded from income tax.
In addition, if you sell your annuity payments before reaching the age of 59 1/2, you will face a tax penalty of 10%. If you reside in a state or territory with an income tax, you will most likely pay state taxes, too.
Some annuities also incur a surrender charge when you sell or withdraw from the annuity before payments begin. And, in most cases, a factoring company won’t offer you the full value of the annuity. This is because they will usually apply a discount rate to determine the present value of the annuity — what it’s worth today based on the time value of money.
As a result, the net amount you receive from selling your annuity payments after taxes, penalties and fees may be significantly less than the full value of your annuity.
Implications for Annuity Transfers
Annuity owners who want to transfer ownership to someone else, such as another family member or trusted friend, will be subject to income taxes on anything earned by the annuity at the time of the transfer.
The only exceptions are when ownership is transferred to a current spouse or to a former spouse in a divorce settlement.
For tax purposes, annuity transfers to friends or family members are treated the same as selling your annuity.
Annuity Gifts
There may also be federal gift taxes that apply to transfers made as gifts. The gift tax rate ranges from 18% to 40%. In general, the person who gives the gift is responsible for paying this tax. The Tax Code provides a lifetime exemption (currently $12.92 million per person in 2023). As long as your total lifetime gifts and estate are below this amount, you don’t have to pay taxes when you gift an annuity.
However, the annual exclusion amount for gifts, according to the IRS, is $17,000 for 2023. If you transfer one or more annuities worth more than $17,000, you must file a gift tax return, even though no tax is due at the time of the gift.
The exclusion applies to all gifts given to the same person or entity in a single tax year. In other words, you may give anyone a total of $17,000 worth of gifts in a single year without having to pay a gift tax.
If you are married, you and your spouse can each make a gift of up to $17,000, which means you can effectively double the amount you can give without incurring the gift tax. For example, you could transfer an annuity of up to $34,000 total without paying gift taxes if you’re married and both you and your spouse agree.
Some states — specifically Connecticut — also collect gift taxes. You should check the laws in your state as state laws may change.
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