How Annuities Are Taxed
Annuities are a great way to help reduce the amount of income tax owed on investments, but Uncle Sam will nonetheless be entitled to tax a portion of withdrawn funds or payments received. Accordingly, it’s smart to formulate a plan to deal with these future taxes.
A primary feature of annuities is that investments can grow tax-free until withdrawal. This means that dividends, capital gains, and interest can be reinvested and continue to grow without being taxed. However, it must be noted that there are many rules and regulations in place that affect when and how annuity funds are subject to taxation.
As always, it’s advisable to consult a tax professional when setting up an annuity so that you’re fully aware of the potential tax implications.
Are Annuities Subject to Taxation?
Yes. Although annuities are allowed to grow tax deferred, there will come a time when the IRS will tax the earnings. This means that taxes will not be owed until the annuitant collects income payments from the annuity. These annuity distributions and withdrawals are unfortunately not taxed as capital gains, but rather as ordinary income.
If an annuitant opens an annuity with funds that have not been previously taxed, then it is considered a “qualified annuity.” In most cases, such annuities are started with funds from a 401(k) or IRA. When payments are made from a qualified annuity, those funds are deemed taxable income since that money was not previously taxed.
On the other hand, withdrawals from annuities started with funds from a Roth 401(k) or Roth IRA are tax-free as long as certain conditions are fulfilled.
When an annuity is opened with after-tax money, then it’s considered a “non-qualified annuity” which carries tax implications on just the earnings. There is a calculation called the “exclusion ratio” used to figure out which percentage of an annuity income is subject to tax and which percentage that is not. Basically, this ratio helps calculate the portion of the annuity payment or distribution that comes from funds that have already been taxed and the portion that is deemed taxable earnings.
This exclusion ratio takes into account the funds that were used to open the annuity, the length of time the annuity has been active, and the interest earnings. In the event an annuitant outlives his/her life expectance (as determined by actuarial tables), then all payments from the annuity made after that age are deemed taxable. The purpose of this approach is to try and allocate distributions of the principal across the annuitant’s life expectancy. After all the principal funds are calculated, then the resulting withdrawals are deemed to be from earnings.
Overall, if an annuitant withdraws money from an annuity prior to age 59 ½, then he or she will likely be required to pay a 10% penalty on the taxable portion of the funds. However, after age 59 ½, if a lump sum withdrawal is made, tax need only be paid on the taxable portion of the withdrawal. Also, if funds remain in the annuity, the IRS will classify the initial and all following withdrawals as interest and they will therefore be taxable.
Generally, monthly income payments from a non-qualified annuity consists of two portions: 1) the tax-free portion that is deemed as repayment of the annuitant’s net cost of the annuity, and 2) the remaining portion that is taxable as earnings. Accordingly, it’s usually wise to plan annuity income payments to spread the principal amount evenly across the total number of payments.
With regard to inherited annuities, the same general rules are applicable: any funds used to purchase the annuity that were already taxed will not be taxable moving forward. However, funds that were not taxed prior to the annuity will be taxed as income.