How is annuity taxed?

When investing in annuities, one of the concerns that people have is how much taxes they will pay. Generally, people invest in annuities to leverage the tax benefits that annuities provide. All annuities are tax-deferred, but there will be tax implications when you start withdrawing money from the annuity.

The taxes you pay on annuities depends on whether you have a qualified or non-qualified annuity. If you have a qualified annuity, you will pay federal income taxes on the full withdrawal. However, if you have a non-qualified annuity, you will only pay income taxes on the earnings portion of the withdrawal, which includes dividends, interest, and capital gains; you won’t pay taxes on the principal component of the withdrawal.

Are annuities taxable?

When you purchase an annuity, you won’t pay taxes on your annuity contributions and earnings until when you start receiving payments. When you make a withdrawal, you will be taxed as ordinary income. The amount of taxes you pay on the withdrawal depends on whether you purchase a qualified annuity (funded with pre-tax dollars) or a non-qualified annuity (purchased with post-tax dollars).

If you have a qualified annuity, you will pay taxes on the full withdrawal at your federal income tax rate. However, if you have a non-qualified annuity, you will only pay taxes on the earnings portion of your withdrawal. The earnings may include dividends, interest, and capital gains.

How are qualified annuities taxed?

Qualified annuities refer to annuities that are purchased with pre-tax dollars, usually through a tax-advantaged retirement account such as a traditional 401(k), 403(b), or IRA. These annuities are not taxed until you start receiving payments from the annuity.

Withdrawals from a qualified annuity are subject to ordinary marginal tax rates, and you will pay income taxes on 100% of the withdrawals. This includes the principal amount (premiums paid) that you paid into the annuity, and any interest, dividends, and earnings. If you are below age 59 ½ at the time of distribution, you will pay an additional 10% early withdrawal penalty unless you qualify for an exemption.

Additionally, qualified annuities are subject to the required minimum distribution (RMD) starting from age 72. You must start taking RMDs from the annuity starting from April 1 of the year after you reach the RMD age. These distributions are subject to income taxes.

How are non-qualified annuities taxed?

Non-qualified annuities are annuities purchased with post-tax dollars, and only the earnings are taxable. Since the money contributed to the annuity has already been taxed, you won’t pay taxes again on the principal amount.

However, the interest and earnings from the non-qualified annuity are subject to federal income taxes. If you are below age 59 ½ at the time of distribution, you may be subject to a 10% early withdrawal penalty. Required Minimum Distributions (RMDs) do not apply to non-qualified annuities, and therefore, you won’t be required to start taking distributions once you reach age 72.

The taxes you pay on a non-qualified annuity is determined by the exclusion ratio. This ratio segregates annuity payments into the principal component and the earnings component. Hence, you will know what percentage of the annuity payment is taxable and which is not subject to income taxes.

Early withdrawals from an annuity

If you take a premature distribution from an annuity, you can expect to pay early withdrawal penalties. Typically, withdrawals made before age 59 ½ are subject to a 10% early withdrawal penalty tax. However, different rules apply to qualified and non-qualified annuities.

If you make an early withdrawal from a qualified annuity, you will pay a 10% early withdrawal penalty on the entire distribution. However, if you make an early withdrawal from a non-qualified annuity, you will only pay a 10% penalty tax on the earnings component of the withdrawal.

Additionally, the early withdrawal may also be subject to surrender charges if the withdrawal is made before the surrender period lapses. The amount you pay as surrender charges varies based on the annuity product you purchase. You should check your annuity contract to know how much fees you will pay.

How to avoid paying taxes on annuities

Here are several options you can use to avoid paying taxes:

Roth IRA annuity

A Roth IRA annuity is purchased with after-tax dollars, and the annuity will grow tax-free over the annuity period. When you make a withdrawal, you won’t pay taxes on the distribution if you meet the requirements for a qualified withdrawal i.e. be age 59 ½ or older and have held the annuity for at least five years. If you don’t meet the requirements for a qualified withdrawal, you will pay income taxes on the distribution at your federal income tax rate.

Charitable gift annuity

This type of annuity allows an individual to make charitable contributions to an organization in exchange for a guaranteed income stream. The payments you receive from a charitable gift annuity may be tax-free or partially tax-free, depending on the terms of the annuity contract.

Long-term care annuity

A care annuity is used to pay for qualified long-term care in a residential care home or in-home care. If the annuity payments are made directly to a registered care home, you won’t pay taxes on these payments. However, if you receive the annuity payments for personal use, part of or all of the payments may be subject to income taxes.

1035 Exchange

A 1035 exchange allows you to swap one annuity for another type of annuity without triggering taxes. You can use a 1035 exchange for qualified and non-qualified annuities. You can swap outdated and underperforming annuities for newer annuities with better features such as a guaranteed lifetime income benefit.

What is the Exclusion Ratio?

If you purchased a non-qualified annuity, you won’t pay income taxes on the principal amount when you withdraw money from the annuity. To determine how much of the withdrawal is subject to income taxes, you can use the exclusion ratio to segregate the principal component and the earnings component.

For example, if you purchase a fixed annuity for $100,000 and you expect to receive $200,000 over a 20-year period, you can calculate the exclusion ratio by dividing the principal by the expected return. In this case, we divide $100,000 by $200,000 to get an exclusion ratio of 50%. This means that 50% of the annuity payments would be considered a return on the initial investment, and the IRS would not assess taxes on this portion. The other 50% would be subject to income taxes as ordinary income.

Once the 20-year period expires, the annuity provider would have returned your principal amount, and all distributions paid thereafter would be subject to income taxes.