Annuity Taxation

Written By : Elaine Silvestrini
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Although annuities are considered a hedge against income taxes, the Internal Revenue Service is still likely to take some of the money you withdraw or payments you receive when the time comes. Figuring that out ahead of time will help you better plan for your financial future.

One of the main tax advantages of annuities is they allow investments to grow tax-free until the funds are withdrawn. This includes dividends, interest and capital gains, all of which may be fully reinvested while they remain in the annuity. This allows your investment to grow without being reduced by tax payments.

But this seemingly simple perk is accompanied by a raft of complicated rules about what funds are taxed, how they are taxed and when they are taxed.

Because of the complexity, it’s best to consult with a tax professional when purchasing an annuity and before withdrawing any funds.

Financial expert, Juliette Fairley explains the tax advantages and disadvantages to owning an annuity.

Are Annuities Taxable?

Annuities are tax deferred. But that doesn’t mean they’re a way to avoid taxes completely. What this means is taxes are not due until you receive income payments from your annuity. Withdrawals and lump sum distributions from an annuity are taxed as ordinary income. They do not receive the benefit of being taxed as capital gains.

Pro Tip
How taxes are determined depends on many factors centering on how the annuity was set up.

How Are Annuities Taxed?

When it comes to taxes, the most important piece of information about your annuity is whether it is held in a qualified or non-qualified account.

Qualified Annuity Non-Qualified Annuity
Funded Untaxed Money After-tax funds
Payments Taxable as income Taxation determined by exclusion ratio

Qualified Annuity Taxation

If an annuity is funded with money on which no taxes have been previously paid, then it’s considered a qualified annuity. Typically, these annuities are funded with money from 401(k)s or other tax-deferred retirement accounts, such as IRAs.

When you receive payments from a qualified annuity, those payments are fully taxable as income. That’s because no taxes have been paid on that money.

But annuities purchased with a Roth IRA or Roth 401(k) are completely tax free if certain requirements are met.

Qualified Annuity Taxation Example

Qualified Image of Annuity Taxation Example
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Qualified Annuity Taxation Example

Non-Qualified Annuity Taxation

If the annuity was purchased with after-tax funds, then it’s non-qualified. Non-qualified annuities require tax payments on only the earnings.

The amount of taxes on non-qualified annuities is determined by something called the exclusion ratio. The exclusion ratio is used to determine what percentage of annuity income payments is taxable and how much is not. The idea is to determine the amount of a withdrawal or payment from an annuity is from the already-taxed principal and how much is considered taxable earnings.

The exclusion ratio involves the principal that was used to purchase the annuity, the amount of time the annuity has existed and the interest earnings.

Pro Tip
The exclusion ratio takes into account 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

  • Your life expectancy is 10 years at retirement.
  • You have an annuity purchased for $40,000 with after-tax money.
  • Annual payments of $4,000 – 10 percent of your original investment – is non-taxable.
  • You live longer than 10 years.
  • The money you receive beyond that 10-year-life expectation will be taxed as income.

Annuity Withdrawal Taxation

How and when you withdraw funds from your annuity also affects your tax bill.

In general, if you take money out of your annuity before your turn 59 1/2, you may owe a 10 percent penalty on the taxable portion of the withdrawal.

After that age, if you take your withdrawal as a lump sum, you have to pay income taxes that year on the entire taxable portion of the funds. If money is left in your annuity account, the IRS considers the first and subsequent withdrawals to be interest and subject to taxes.

Annuity Payout Taxation

According to the General Rule for Pensions and Annuities by the Internal Revenue Service, as a general rule, each monthly 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 evenly divide the principal amount — and its tax exclusions — out over the expected number of payments. The rest of the amount in each payment is considered earnings subject to income taxes.

Inherited Annuity Taxation

If you are the beneficiary and inherit an annuity, the same tax rules apply. The main rule about taxation with an inherited annuity or one that is purchased is that any principal that is funded with money that was already subject to taxes will still not be taxed. Principal that was not taxed and earnings will be subject to taxation as income. The amount of previously taxed principal included in each annuity income payment is considered excluded from federal income tax requirements. This is known as the exclusion amount.

12 Cited Research Articles

  1. Internal Revenue Service. (n.d.). Topic Number 410 – Pensions and Annuities. Retrieved from https://www.irs.gov/taxtopics/tc410
  2. Sahadi, J. (2018, May 11). Before choosing an annuity, know the tax implications. Retrieved from https://money.cnn.com/2018/05/11/pf/taxes/annuities-taxes/index.html
  3. White, H. (2018. July 28). Tax Planning for Annuities. Retrieved from http://www.myprimetimenews.com/tax-planning-for-annuities-2/
  4. Lankford, K. (2017, August 9). Figuring out taxes on variable annuity withdrawals. Retrieved from http://www.chicagotribune.com/business/success/kiplinger/tca-figuring-out-taxes-on-variable-annuity-withdrawals-20170809-story.html
  5. Connick, W. (2017, September 13). Will My Annuity Payments be Taxed? Retrieved from https://www.fool.com/taxes/2017/09/13/will-my-annuity-payments-be-taxed.aspx
  6. Investopedia. (n.d.). Exclusion Ratio. Retrieved from https://www.investopedia.com/terms/e/exclusionratio.asp
  7. ThinkAdvisor. (n.d.). Question About Exclusion Ratio. Retrieved from https://www.thinkadvisor.com/2009/05/26/ask-the-expert-how-to-explain-the-exclusion-ratio/
  8. Insured Retirement Institute. (n.d.). Taxation of Annuities. Retrieved from http://www.irionline.org/government-affairs/annuities-regulation-industry-information/taxation-of-annuities
  9. Brantley, C. (n.d.) Do I Have to Pay Taxes on an Inherited Annuity of My Deceased Father? Retrieved from https://budgeting.thenest.com/pay-taxes-inherited-annuity-deceased-father-34329.html
  10. Investopedia. (n.d.). What are the distribution options for an inherited annuity? Retrieved from https://www.investopedia.com/ask/answers/09/inherited-annuity-distribution.asp
  11. Investopedia. (n.d.). Taxation of Annuities. Retrieved from https://www.investopedia.com/exam-guide/cfp/selection-and-annuities/cfp7.asp
  12. Internal Revenue Service. (2013, December). General Rule for Pensions and Annuities. Retrieved from https://www.irs.gov/pub/irs-pdf/p939.pdf
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