Annuity Taxation

“One of the biggest benefits of annuities is the ability to grow on a tax-deferred basis,” says Paul Tyler, an annuity and retirement expert. 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.

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.

“When you take distributions or withdraw from the annuity later in retirement,” Tyler says, “you will be taxed on the growth at your then-current tax rate.” 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.

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.

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.

If the contract was purchased with after-tax funds — meaning money that has been reported to the IRS as income and taxed accordingly — then the annuity is 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. Essentially, this entails segregating the annuity payments into a principal component (not taxable) and an earnings component (taxable).

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.

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.

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

In general, if you withdraw money from your annuity before you turn 59 ½, you may owe a 10% penalty on the taxable portion of the withdrawal. 

After that age, taking your withdrawal as a lump sum rather than an income stream will trigger the tax on your earnings. You’ll have to pay income taxes that year on the entire taxable portion of the funds.

Regardless of how you withdraw the money, the tax status of the contract, whether qualified or non-qualified, determines how much of the withdrawal will be taxed. If it’s a qualified annuity, you will pay taxes on the full withdrawal amount. If it is non-qualified, you will pay income taxes on the earnings only.

Taxation of non-qualified annuity withdrawals uses last-in-first-out (LIFO) tax rules. This means that any withdrawal amounts are taxed first as the annuity’s growth element and are subject to ordinary income tax. 

Once the amount withdrawn exceeds the value the annuity has gained, subsequent withdrawal amounts are considered a tax-free return of your principal and you won’t owe taxes on that amount.

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.

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.

Once you begin receiving annuity payments, you’ll need to report that income on your tax return. You can do so using a 1099-R form.

Taxpayers use 1099-R forms to report distributions from retirement savings products including annuities, retirement plans and pensions. If you’ve received a distribution of $10 or more from any of the retirement income sources, also known as payers, you must file a 1099-R form when you file your taxes.

You should receive a 1099-R form on or before Jan. 31 of each year for distributions received during the previous calendar year. Taxpayers who receive distributions from multiple payers will receive multiple forms.

What Is Publication 575?

The IRS updates Publication 575, a guide on how to report distributions from pensions and annuities, every year. The detailed document explains how distributions are taxed and how to report that income on your tax return.

Other topics covered by Publication 575 include information on rolling over certain distributions from one retirement plan to another; how to report disability payments; how to report railroad retirement benefits; and how to determine which part of an annuity payment is tax-free.

You can find Publication 575 on this IRS page.