How to Avoid Paying Taxes on Your Annuity

An annuity is a financial product offered by insurance companies. It often appeals to risk-averse investors or those who have maxed out their retirement accounts. One key advantage of an annuity is the lack of contribution limits, unlike 401(k)s and IRAs. Additionally, earnings grow tax-deferred, allowing for potential long-term growth without immediate tax liabilities. If you’re considering an annuity for retirement income or as an additional investment, we’ll cover what you might want to consider regarding annuities and taxes. You can also consider consulting with a financial advisor for help in determining if it’s the right fit for your financial goals.

Annuities and Taxes

Purchasing an annuity is a tax-deferred way of increasing your retirement savings. It’s a contract between you and an insurance company that will pay you regular payments either beginning at the time of purchase or at some point in the future. It can be a way to increase and protect your retirement savings.

There’s no limit on how much you can contribute to an annuity, unlike a 401(k) or an individual retirement account (IRA). Annuities have the same early withdrawal taxation rules as other retirement accounts. If you make a withdrawal, you’ll be subject to taxes and a 10% early withdrawal penalty.

One of the advantages of buying an annuity is that the earnings are allowed to grow on a tax-deferred basis until withdrawal. Earnings include interest, dividends and capital gains. The earnings are reinvested each year without any tax impact. However, there are disadvantages, including the rate at which you’re taxed. One factor that determines the taxation of annuities is whether you have a qualifying or non-qualifying annuity.

Taxation on Qualified Annuities

How annuities are taxed depends on whether your account is a qualified or a non-qualified account. A qualified annuity has been purchased with pre-tax dollars. If you use the money from a 401(k), 403(b), traditional IRA, SEP-IRA or SIMPLE IRA to purchase an annuity, it will be classified as a qualified annuity. This is because those are all funded with pre-tax dollars.

The payments from this type of annuity are fully taxable as ordinary income, but not until you make a withdrawal or start receiving payments. If you make an early withdrawal, you may have to pay your full contribution to the annuity, plus the 10% penalty.

Taxation on Non-Qualified Annuities

Non-qualified annuities are funded with after-tax dollars. If you buy your annuity using money from a regular savings or money market account or a taxable brokerage account, you don’t have to pay taxes on withdrawals or periodic payments from your principal amount. That’s because a non-qualified annuity is funded with after-tax dollars.

You do have to pay taxes on the earnings of your contribution to the annuity when you make a withdrawal or receive a payout. Earnings are dividends, interest and capital gains. The amount of your withdrawal or payment from investments is subject to the exclusion ratio. The exclusion ratio refers to the portion of your contribution to an annuity that’s taxed upon withdrawal.

Because investors fund a non-qualified annuity with after-tax dollars, the exclusion ratio determines the annuity’s earnings, which remain untaxed until withdrawal. Investors must pay taxes when they withdraw funds, but the earnings can grow tax-free in the meantime.

If you own a nonqualified variable rate annuity, you have a tax advantage over other nonqualified accounts like mutual funds or brokerage accounts. If you have investments in those types of accounts, you pay taxes on the capital gains distributions, interest and dividends that you receive at the end of every tax year.

In contrast, the nonqualified variable rate annuity does not have any tax liability until you start making withdrawals or taking payouts. Bear in mind that your earnings, when they are withdrawn, are taxed at the ordinary income tax rate, not the more favorable capital gains tax rate. Another disadvantage is there’s no opportunity for Roth conversions.

Taxation of Other Classifications of Annuities

There are also immediate and deferred annuities, and fixed and variable annuities, each with their own way of functioning:

• Fixed and Variable Annuities. A fixed annuity offers you a set interest rate for a certain amount of time. It is not linked to market performance. As long as you do not withdraw your investment gains and keep them in the annuity, they are not taxed. A variable annuity is linked to market performance. If you do not withdraw your earnings from the investments in the annuity, they are tax-deferred until you withdraw them.
• Immediate and Deferred Annuities. An immediate annuity is usually purchased with a large contribution, and payout begins immediately and lasts as long as you live. A deferred annuity does not offer a payout until interest is accrued on your contributions. For both these types of annuities, the earnings grow tax-deferred until you start taking the payouts.

Other Types of Annuity Taxation

If you inherit an annuity, the same tax rules apply if you are the spouse of the annuitant. You can choose to receive your payouts according to the annuity schedule. In that case, taxes are deferred until you make withdrawals or receive your payouts. If you are not the spouse of the annuitant, the tax status depends on how to receive your payouts. 

When an annuity owner dies with a remaining balance, their beneficiaries must fulfill a tax obligation. The tax is based on the difference between the premiums paid and the remaining balance at the time of death. If the annuity includes a death benefit, the IRS generally treats it as taxable income, unlike life insurance payouts.

To avoid paying taxes on your annuity, you could consider a Roth 401(k) or a Roth IRA as a funding source. Then, you do not pay taxes upon withdrawal since Roth accounts are funded with after-tax dollars.

Bottom Line

When considering if an annuity makes sense for you, remember that the advantage is that earnings grow tax-free until withdrawal. However, you pay for that advantage by taxation at the higher ordinary income rate when you do make a withdrawal and a lower return on your investment. For very risk-averse investors, annuities may be an option because, in some cases, your principal is protected. Another advantage of annuities is that there is no maximum retirement contribution. This makes them an extra investment possibility after you max out your retirement accounts.

Retirement Tips

• Saving and investing for retirement can be a difficult task, but a financial advisor may be able to help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Planning for retirement and your financial future can be intimidating, so it’s important to stay prepared. SmartAsset has you covered with a number SmartAsset’s 401(k) calculator. It helps you plan your retirement by showing you the value of your 401(k) over time.

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