How Different Annuities Are Taxed
August 5, 2020
As the saying goes, two things are certain: death and taxes. Annuities can’t prevent the first, and taxes on them must be paid eventually. But the type of annuity you purchase or contribute to affects how much of your money will be taxed, and at what time. As with any kind of financial product, individual circumstances affect how rules apply. This summary of how different annuities are taxed is offered as general information – be sure to consult your tax advisor before making any decisions about purchasing, contributing to, or withdrawing money from an annuity.
Contributions, Capital Gains, Interest, Income, and Withdrawals
Money is money, but the IRS defines it in different ways, especially when it comes to annuities. An annuity is a contract with an insurance company. The contract promises the annuitant (the purchaser of the annuity) a regular payout beginning at a certain time or when the annuitant reaches a certain age, over a fixed number of years, or throughout the annuitant’s lifetime. What happens from the time the contract is made until the time payouts begin, as well as what happens after an annuitant dies, all affect how the purchase money is taxed.
Annuities can be purchased in a lump sum, or with several contributions over time. People who are still years from retirement can make regular contributions to an annuity and allow the money to grow over time. That timespan is called the “accumulation period.” The insurance company that offers the annuity contract will take those contributions and invest them, usually in mutual funds and bonds. As those investments grow in value (capital gains) or pay dividends and interest, the value of the annuity grows, increasing the amount of future payouts when the annuitant reaches retirement age, or the agreed-upon date when payouts begin. The payouts, as well as withdrawals, are treated as income in the year they are received. Principal, or the money you paid to buy the annuity, also affects how annuities are taxed, depending on whether that purchase money had already been taxed or not.
Contributions to Qualified vs. Non-Qualified Annuities
The most significant differentiation is whether the annuity is a “qualified” or “non-qualified” one. A “qualified” annuity is one that you purchase with money that hasn’t already been taxed, like pre-tax contributions taken from your paycheck and invested in a 401(k), or your tax-deferred contributions to your IRA (up to IRS limits). The money you put into a qualified annuity grows tax deferred. You only pay taxes on it when you take a withdrawal or begin payouts, when it is taxed as ordinary income . The only exceptions are income from annuities paid for with money from Roth IRAs or Roth 401(k)s, if IRS requirements are satisfied. If you are thinking of buying an annuity with money you invested in a Roth IRA or Roth 401(k), talk to your tax advisor first so you understand the requirements.
A “non-qualified” annuity is one that was purchased with money that has already been taxed. Taxes will be due only on the earnings of a non-qualified annuity. However, the calculation of the tax is made according to a formula called the “exclusion ratio.” The exclusion ratio determines what percentage of a payout or withdrawal comes from money that had already been taxed, and which portion comes from earnings on that money that hasn’t been taxed yet.
The exclusion ratio also takes the annuitant’s life expectancy into consideration. The ratio is meant to distribute the non-taxable principal over the purchaser’s lifetime, based on the actuarial calculation of life expectancy. If you purchase a non-qualified annuity and end up living longer than the life expectancy of the actuarial prediction, all the money paid out from that point forward will be taxable.
Withdrawals vs. Payouts
The IRS imposes harsh penalties for money withdrawn from annuities before age 59 1/2. Before that age, if you take a lump sum withdrawal, you must pay a 10% early withdrawal penalty, in addition to paying income tax on the earnings. On top of that, many annuities charge “surrender fees” for taking money out earlier than planned. These fees can be steep, especially if you haven’t owned the annuity for very long. Read the fine print about withdrawal penalties before you choose the right annuity for you.
Even if you are older than the minimum age for withdrawals without penalty, you should know that if you take a lump-sum withdrawal, you’ll pay taxes on the entire amount the year you withdraw the money. That can put a significant dent in your principal and leave you with lower earnings and thus less income for your retirement. The point of an annuity is to spread your money out over the remainder of your lifetime or throughout the number of years the contract specifies. If you take it all at once, you’ll pay taxes, and unless you are a financial wizard, you may risk losing more money depending on how you invest the money you withdrew.
Payouts, on the other hand, take the form of an agreed-upon income stream, and they are usually paid monthly. For qualified accounts, these payouts are taxed as regular income. Non-qualified annuities are subject to the exclusion rate calculation to determine the tax on their payouts and in order to figure out how much of each payout should be treated as returned principal and not taxed, as well as how much is earnings that should be taxed. Most retirees who begin payouts are in a lower tax bracket than they were when they were earning a salary or wages, so the tax rate on annuity income payouts may be lower. But the bottom line is that taxes are certain – you will either pay them before you put money into an annuity or when you take it out.
Generally speaking, if you assign a beneficiary to inherit your annuity payments after you die, those payments will be subject to the same kind of tax rules as they would have been for you. If the beneficiary is your spouse, they can elect to take payments in the same way and on the same schedule as you did. If the beneficiary is not the annuitant’s spouse, then there are a variety of scenarios that may apply.
Non-spouse beneficiaries can take a lump sum and pay taxes on the annuity the year they receive it. Or, they can spread payments out over five years, paying taxes on the amount received each year. That rule requires that the entire remainder of the annuity be paid out over the five-year period. Other rules may allow a non-spousal beneficiary to stretch payments out over the rest of their life. The choice comes down to either taking a large lump sum that gets the beneficiary’s money more quickly but also applying a big tax bill or taking less money all at once with payments spread over time and paying less tax over more time. Beneficiaries may be able to exchange an inherited annuity for one of their own of the same type (qualified or non-qualified) if they find an annuity which offers better terms. Or, they may be able to roll the annuity into the deceased’s IRA, if the beneficiary also inherited that account.
As you can see, knowing the answer to “what are the different types of annuities” will have an important impact on the annuity you choose and to the tax treatment of withdrawals and payouts when the time comes. Consult an experienced, qualified annuity broker to discuss your options, and check with your tax advisor before you decide what type of annuity is best for you.
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