How Are Annuities Taxed? Start With Where the Money Came From

How are annuities taxed? The answer usually begins with two questions: Where did the money come from, and how will you receive it back?

Those questions tell you more than the word annuity does. An annuity purchased inside a traditional IRA generally follows the IRA's tax rules. An annuity purchased with savings that have already been taxed follows a different set of rules.

My view is that taxes should be understood before you purchase an annuity, but they should not be the reason you purchase one. Start with the job you need the money to do. Then decide whether the benefits, restrictions, costs, and tax treatment fit that need.

Prefer to Listen or Watch?

This article was adapted from Episode 118 of The Simply Retirement Podcast. The episode page includes both the audio player and the YouTube video: Listen to or watch How Are Annuities Taxed? A Simple Guide for Retirement

First, Identify the Source of the Money

The first distinction is whether the annuity is qualified or nonqualified. These terms describe how the contract is funded. They do not describe the quality of the annuity.

Qualified annuity

A qualified annuity is generally held inside a tax-advantaged retirement account or plan, such as a traditional IRA or an employer retirement plan. The retirement account usually determines how distributions are taxed.

Think of the retirement account as an umbrella. Under that umbrella, you might own mutual funds, stocks, CDs, or an annuity. Changing the investment does not normally change the tax rules attached to the account.

If an annuity is held inside a traditional IRA, distributions are generally taxed under the IRA rules. The contract also generally remains subject to IRA requirements, including required minimum distribution rules. Purchasing an annuity inside the IRA does not create an extra layer of tax deferral because the IRA already provides it.

The reason to consider an annuity inside a retirement account would be its contract benefits. You might want a defined income stream, principal protection for part of your savings, or less exposure to market swings. The tax deferral by itself is not an additional benefit in that setting.

What about a Roth IRA?

The same basic principle applies to a Roth IRA. The Roth IRA rules determine the tax treatment. Qualified Roth IRA distributions are generally tax-free when the applicable requirements have been met. Holding an annuity inside the Roth does not create that tax treatment or change it.

Nonqualified annuity

A nonqualified annuity is funded with money outside a retirement account. The money might come from savings, a brokerage account, an inheritance, life insurance proceeds, or the sale of an asset. What matters here is that the money is not being held under IRA or employer-plan tax rules.

The after-tax amount placed into the contract is your investment in the contract, often called your cost basis. The earnings may grow tax-deferred while they remain inside the annuity. Tax deferral postpones the tax on those earnings until money comes out. It does not eliminate it.

How a Nonqualified Annuity Withdrawal Is Taxed

Suppose you place $100,000 of after-tax savings into a nonqualified annuity. Over time, the contract grows to $130,000. Your original $100,000 is your investment in the contract, and the additional $30,000 represents earnings.

If you take withdrawals before converting the contract into a stream of annuity payments, the tax rules generally treat the earnings as coming out first. This is often called last in, first out, or LIFO, treatment.

In this example, the first $30,000 withdrawn would generally be taxable as ordinary income. Once the earnings have been withdrawn, additional withdrawals would generally be treated as a return of the $100,000 you already contributed and would not usually be taxed again.

This is different from the way long-term gains may be taxed in a brokerage account. Taxable annuity earnings are generally taxed as ordinary income rather than at long-term capital gains rates.

What Happens Before Age 59 1/2?

If you receive a taxable distribution from an annuity before age 59 1/2, an additional 10% federal tax may apply unless an exception is available. For a nonqualified annuity, the additional tax generally applies to the taxable portion of the distribution, not to the return of your after-tax investment.

An insurance company may also impose a surrender charge under the contract. A surrender charge and the federal additional tax are separate. You should understand both before deciding how much access you may need to the money.

How Annuity Payments Are Taxed

The tax treatment changes when a nonqualified annuity is converted into a series of regular annuity payments. This process is commonly called annuitization.

When you annuitize, each payment is generally divided between a return of your investment and taxable earnings. The portion treated as a return of your investment is generally excluded from income. The earnings portion is generally taxed as ordinary income.

The IRS method used to determine the taxable and nontaxable portions is often called the exclusion ratio. You do not need to calculate it from memory. The practical point is that a regular annuity payment can contain both taxable income and a tax-free return of money you previously contributed.

That differs from taking occasional withdrawals, where earnings generally come out first. The way you plan to receive the money can therefore change when the taxable income is recognized.

Tax Deferral Has a Trade-Off

Tax deferral may allow earnings to remain in the contract without being taxed each year. That can be useful in the right circumstances, especially when the money is intended for a later retirement need.

The trade-off is that the earnings will generally be taxed as ordinary income when withdrawn. You may also face restrictions, surrender charges, or contract fees. Tax deferral should be evaluated alongside those terms rather than treated as a stand-alone reason to buy an annuity.

Three Questions to Ask Before You Decide

The tax rules become easier to follow when you work through the same three questions we used in the episode:

·         Where did the money come from? Determine whether the annuity will be held inside a retirement account or funded with after-tax money.

·         How do you expect to receive the money? Occasional withdrawals and regular annuity payments can be taxed differently.

·         Why are you considering the annuity? Identify the retirement need before deciding whether the contract benefits and trade-offs are worthwhile.

That last question deserves the most attention. A favorable tax feature cannot make an annuity appropriate if the contract does not solve a specific retirement need.

Frequently Asked Questions About Annuity Taxes

Does an annuity inside an IRA provide additional tax deferral?

Generally, no. A traditional IRA already provides tax deferral. The annuity may offer income guarantees or other contract benefits, but it does not add another layer of tax deferral to the IRA.

Are nonqualified annuity withdrawals taxed as capital gains?

Generally, no. Taxable earnings withdrawn from a nonqualified annuity are usually taxed as ordinary income. Your after-tax investment in the contract is generally not taxed again when it is returned to you.

Is the entire annuity payment taxable?

It depends on the source of the money and the form of payment. Payments from a traditional IRA are generally taxable under the IRA rules. Payments from an annuitized nonqualified contract generally include both a taxable earnings portion and a nontaxable return of your investment until that investment has been recovered.

Do annuities avoid taxes?

No. A nonqualified annuity generally defers tax on its earnings until money is distributed. Tax deferral changes when the tax is paid. It does not automatically eliminate the tax.

Understand the Tax Rules, Then Return to the Retirement Need

Annuity taxation can feel complicated because several rules may apply to the same contract. The clearest starting point is the source of the money. After that, look at how you expect to receive it.

Once those answers are clear, return to the planning decision. What do you need this money to do? If the annuity provides a benefit your retirement plan needs and the trade-offs are acceptable, it may deserve consideration. The tax treatment is one part of that decision.

Does an Annuity Fit Within Your Financial Plan?

Our free checklist can help you organize the questions to consider before purchasing an annuity or reviewing one you already own. Download Does an Annuity Fit Within My Financial Plan?

If you would like to see how retirement income, investments, and taxes work together in your situation, learn more about the Simply Retirement Roadmap™.

Disclosure

Annuities are insurance products issued by insurance companies and involve costs, fees, limitations, and contractual terms that vary by product. Guarantees are backed solely by the claims-paying ability of the issuing insurance company. Before purchasing an annuity, investors should carefully consider their financial objectives, risks, charges, expenses, and contract features, and consult with their financial, tax, and legal professionals.

Content here is for illustrative purposes and general information only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy.

Information here is provided, in part, by third-party sources. These sources are generally deemed to be reliable; however, neither Blake Wealth Management nor RFG Advisory guarantee the accuracy of third-party sources. The views expressed here are those of Blake Wealth Management. They do not necessarily represent those of RFG Advisory, their employees, or their clients.

This commentary should not be regarded as a description of advisory services provided by Blake Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.