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One key advantage of an annuity is that its earnings grow tax-deferred, which allows for potential long-term growth without immediate tax liabilities. However, upon withdrawing funds, taxes generally apply. The taxation of withdrawals varies depending on how the annuity was funded. There are steps you can take to either reduce or temporarily avoid taxes on annuities.
You can also consider consulting with a financial advisor for help determining if an annuity suits 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 provides regular payments either beginning at the time of purchase or at some point in the future.
There’s no limit on how much you can contribute to an annuity, unlike with a 401(k) or an individual retirement account (IRA). However, distributions taken before age 59 ½ may be subject to a 10% additional federal tax on the taxable portion unless an IRS exception applies.
One of the advantages of buying an annuity is that the earnings grow on a tax-deferred basis until withdrawal. Earnings include interest, dividends and capital gains. The earnings are then reinvested each year without any tax impact. Upon withdrawing funds, however, taxes do generally apply.
How Different Types of Annuities Are Taxed
How annuities are taxed largely depends on whether your account is a qualified or a non-qualified annuity. Other factors, such as whether an annuity is fixed or variable, or immediate or deferred, can also have a bearing on taxation.
Taxation of Qualified Annuities
A qualified annuity is one that was 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. These retirement accounts are commonly funded with pre-tax dollars, although some can also contain after-tax amounts.
Payments from a qualified annuity are generally taxable as ordinary income to the extent they consist of money that has not already been taxed. If you have after-tax basis in the plan or contract, part of a payment may be excluded from taxable income. A distribution before age 59 ½ may also be subject to the 10% additional tax on the taxable portion unless an exception applies.
Taxation of Non-Qualified Annuities
Non-qualified annuities are purchased with after-tax dollars, meaning you’ve already paid income tax on the funds that were used to buy the annuity. When you begin taking withdrawals, the portion of your payment that represents a return of your original investment (principal) is not taxed again. Only the earnings portion, meaning any interest, dividends and capital gains, is taxable as ordinary income.
The tax treatment depends in part on whether you are taking withdrawals from a deferred annuity or receiving annuity payments. For withdrawals from many non-qualified deferred annuities, earnings generally come out before your investment in the contract. In other words, taxable gain is generally distributed first. Once a contract is annuitized, each payment can contain both a taxable portion and a tax-free return of your investment, calculated under the applicable annuity rules.
If you take a withdrawal before age 59½, the taxable portion is also subject to a 10% early withdrawal penalty, unless an IRS exception applies. This penalty applies on top of ordinary income tax on the earnings.
Unlike mutual funds or taxable brokerage accounts, where taxes apply annually to earnings, non-qualified annuities offer tax deferral. You don’t pay tax on earnings until you withdraw them. However, when you do, ordinary income rates, not capital gains tax rates, apply.
Estimate your overall income tax liability with our calculator to see how your earnings may affect what you owe.
Taxation of Other Classifications of Annuities
Other types of annuities have their own way of functioning. Here’s a look at the taxation rules for other types of annuities:
- Fixed and variable annuities: Both fixed and variable annuities offer tax-deferred growth, meaning you don’t pay taxes on earnings until you withdraw them. A fixed annuity pays a guaranteed interest rate that isn’t the market does not affect. Returns on a variable annuity, on the other hand, depend on market performance. For non-qualified contracts, taxable earnings are generally treated as ordinary income rather than capital gains. A distribution before age 59½ may also trigger a 10% additional tax on its taxable portion unless an exception applies.
- Immediate and deferred annuities: Payouts on a immediate annuity begin immediately and may last as long as you live. A deferred annuity, on the other hand, offers payout at some point in the future. This allows for interest to accrue on your contributions. For both of these types of annuities, earnings grow tax-deferred until you start taking payouts.
Annuity Taxation During the Payout Phase
Once an annuity enters the payout phase, the tax treatment of each payment depends on how the contract was funded. For a qualified annuity funded entirely with pre-tax money, payments are generally taxable as ordinary income. If the qualified account contains after-tax basis, a portion of the payments may be tax-free.
Non-qualified annuities follow a different rule. Part of each payment represents a return of your principal, which is not taxed. Another part represents your earnings, which are taxed as ordinary income. For annuity payments from a non-qualified contract, the tax-free portion is generally determined using the General Rule. This rule takes into account the owner’s investment in the contract and expected return.
Once the principal portion has been fully paid out, all subsequent payments become fully taxable. This shift is important for long-term income planning, especially for lifetime annuities, where payments may continue for years after the exclusion ratio ends.
Taxes also depend on the payout option selected. Lifetime payouts, period-certain payouts and joint-life payouts all follow the same basic rules, but the expected payment duration affects the calculation of the exclusion ratio. Understanding how these rules apply can help annuity owners estimate after-tax income and plan for long-term cash flow during retirement.
Ways to Reduce or Defer Taxes on an Annuity
An annuity generally cannot make taxable earnings permanently tax-free. However, several decisions can affect when income is recognized and how much of a payment is taxable.
- Hold off on making a taxable distribution. One option is to leave earnings inside a non-qualified deferred annuity until you need the money. Because growth within the contract is tax-deferred, federal income tax on those earnings generally is postponed until a taxable distribution occurs.
- Consider a Section 1035 exchange. If the goal is to replace an existing annuity rather than take the money for personal use, a Section 1035 exchange may preserve tax deferral. A qualifying exchange can move value from one annuity contract to another without recognizing the accumulated gain at the time of the exchange. The exchange effectively postpones the tax, rather than eliminating it.
- Time withdrawals carefully. Owners approaching retirement can also review the timing of withdrawals. Taking a taxable distribution in one year over another can affect the marginal federal income tax rate that applies to the distribution. This is because annuity earnings are generally ordinary income. Ultimately, though, the result depends on the owner’s other taxable income, filing status and the amount withdrawn.
- Avoid early withdrawals. For someone younger than 59 ½, waiting to take a distribution can have another potential tax effect. The 10% additional federal tax generally applies to the taxable portion of an early annuity distribution, but only until the owner reaches age 59½. IRS exceptions can also apply before that age. Contract surrender charges are separate from federal taxes. Make sure to review those before making a withdrawal or exchange.
Bottom Line
The tax treatment of annuities depends on how the annuity was funded. Qualified annuity distributions are generally taxable as ordinary income to the extent they consist of previously untaxed money. With non-qualified annuities, after-tax investment in the contract is not taxed again. Earnings, however, are generally taxable as ordinary income. Taxable distributions before age 59½ may also face a 10% additional federal tax unless an exception applies.
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. Then, you can have a free introductory call with your advisor matches to decide which one 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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