How Are Annuities Taxed?

Shawn Plummer

CEO, The Annuity Expert

If you’re considering an annuity, one of the first questions you’ll want to ask is how they are taxed. The answer may surprise you, as there are a few different ways that annuities can be taxed. In this guide, we will discuss the various ways that annuities are taxed and help you understand exactly how they are taxed. We will also provide a complete guide to understanding annuity taxation so that you can make the best decision for your needs!

Are Annuities Taxable?

The first question you might have is whether or not annuities are taxable. The answer to this question is both yes and no. All annuities are taxable except a Roth annuity.

How Are Annuities Taxed?

The first thing to understand is that annuities are not taxed at the time of purchase. This means that you can put as much money into an annuity as you want without having to worry about paying taxes on it immediately. However, this also means that you will not be able to deduct the amount of your purchase from your taxes.

The money in your annuity will grow tax-deferred, which means that you will not have to pay taxes on the growth of your investment until you start taking withdrawals. This can be a significant advantage, as it allows your money to grow without being taxed each year. When you do take withdrawals from your annuity, they will be taxed as ordinary income. This means that you will pay the same tax rate on your withdrawals as you would on any other type of income, such as wages from a job.

Of course, there are some exceptions to these general rules. For example, if you use an annuity to fund a qualified retirement plan, such as an IRA or 401(k), the money in your annuity will be taxed differently. We will discuss these exceptions in more detail below.

Qualified Plans

If you use an annuity to fund a qualified retirement plan, such as an IRA or 401(k), the money in your annuity will grow tax-deferred and will not be taxed until you start taking withdrawals. This is because the money in your annuity is considered to be invested in a qualified retirement plan.

There are some important things to keep in mind if you use an annuity to fund a qualified retirement plan. First, you will not be able to take any tax deductions for the amount of your annuity contribution. Second, the rules for taking withdrawals from a qualified retirement plan will apply to your annuity. This means that you may be subject to penalties if you take withdrawals before you reach retirement age.

Qualified Annuities

If the annuity is a qualified annuity, such as an IRA, the earnings in the account will not be taxed when they are withdrawn. If the annuity is a non-qualified annuity, the earnings in the account will be taxed when they are withdrawn.

Qualified annuities include:

  • IRAs
  • 401(k)s
  • 403(b)s
  • 457s
  • Deferred Compensation Plans

Non-Qualified Plans

If you have a non-qualified annuity, the money in your annuity is not considered to be invested in a qualified retirement plan. This means that the money in your annuity will be taxed as ordinary income when you start taking withdrawals.

There are some advantages to having a non-qualified annuity. First, you can take tax deductions for the amount of your annuity contribution. Second, you can take withdrawals from your annuity at any time without penalty.

The downside of having a non-qualified annuity is that the money in your annuity will be subject to taxation when you start taking withdrawals. This means that you could end up paying more in taxes than you would if you had a qualified annuity.

Non-qualified Annuities

Non-qualified annuities do not have the same tax benefits as qualified annuities.

The earnings in a non-qualified annuity are taxed when they are withdrawn.

Non-qualified annuities include:

  • Annuities that are not part of a retirement plan
  • Life insurance policies that have an investment component
  • Fixed and variable annuities that are not part of a retirement plan

How much tax do you pay on annuity income?

Income from an annuity is taxed as ordinary income, which means that you will pay the same tax rate on your withdrawals as you would on any other type of income, such as wages from a job. The exact amount of tax you will pay will depend on your marginal tax bracket.

Qualified AnnuityRoth AnnuityNon-Qualified Annuity
Funded WithPre-taxed MoneyAfter-Tax MoneyAfter-Tax Money
Withdrawals100% TaxableTax-FreeInterest-Only Taxed (LIFO)
Annuitized Payments100% TaxableTax-FreeExclusion Ratio
RMDSYesNoNo

Early Withdrawal Penalties

If you take withdrawals from your annuity before you reach retirement age, you may be subject to early withdrawal penalties. The amount of the penalty will depend on the type of annuity you have and the rules of your particular plan.

  • Qualified Annuities: If you have a qualified annuity, you may be subject to a ten percent early withdrawal penalty on the entire amount if you take withdrawals before you reach retirement age.
  • Non-Qualified Annuities: If you have a non-qualified qualified annuity, you may be subject to a ten percent early withdrawal penalty on any interest earned if you take withdrawals before you reach retirement age. 

How can I avoid paying taxes on annuities?

There are three ways to avoid paying taxes on annuities, purchasing a Roth Annuity or Charitable Gift Annuity for retirement income, and a long-term care annuity to pay for qualified long-term care facilities and services.

Roth IRA Annuity

A Roth annuity is a type of qualified annuity that is funded with after-tax dollars. This means that you will not be able to deduct the amount of your contribution from your taxes. However, the money in your Roth annuity will grow tax-free and you will not have to pay taxes on your withdrawals, as long as you meet the requirements for a qualified withdrawal.

To make a qualified withdrawal from a Roth annuity per the IRS, you must meet two requirements:

  • You must have held the annuity for at least five years.
  • You must be age 59½ or older, or you must be disabled or deceased.

Long-Term Care Annuity

A long-term care annuity is an annuity that is used to pay for qualified long-term care facilities and services. The money in a long-term care annuity can be used to pay for any type of long-term care, including in-home care, nursing home care, and assisted living.

The money in a long-term care annuity is not subject to taxation. This means that you will not have to pay taxes on your withdrawals, as long as you use the money to pay for qualified long-term care expenses.

Charitable Gift Annuity

A charitable gift annuity is an annuity that is given to a charity. The charity uses the money from the annuity to fund its programs and services. The money in a charitable gift annuity is not subject to taxation. This means that you will not have to pay taxes on your withdrawals, as long as you use the money for qualifying charitable purposes.

How does retirement annuity reduce tax?

A non-qualified annuity is an annuity that is not funded with qualified retirement plan dollars. Only the earnings on the annuity are taxed when you start taking withdrawals. You will not have to pay taxes on your contributions, and you can take withdrawals at any time without penalty.

Last In First Out (LIFO)

The Last In First Out method is used with withdrawing money from an annuity or using a lifetime income rider to distribute income.

This is the method used to calculate the order in which withdrawals are taken from an annuity. With this method, the earnings are withdrawn first, and the contributions are withdrawn last. This is advantageous if the earnings have grown significantly because only the earnings will be subject to taxation.

The withdrawal of funds from a retirement annuity is taxed as ordinary income. The Internal Revenue Service (IRS) taxes the withdrawal of funds from a retirement annuity at the taxpayer’s marginal tax rate. Marginal tax rates range from ten percent to thirty-seven percent for 2019.

Exclusion Ratio

The exclusion ratio is used when annuitizing an annuity contract to distribute annuity payments.

The amount of each withdrawal is considered a return of investment (principal) and is not taxed.

The exclusion ratio is used to determine how much of a withdrawal from an annuity is taxable. The exclusion ratio is calculated by dividing the total contribution to the annuity by the expected return on investment. For example, if you had contributed $100,000 to an annuity and the expected return on investment was $200,000, the exclusion ratio would be 50%. This means that 50% of each withdrawal would not be taxed.

Are there tax consequences when an annuity is assigned?

An annuity can be assigned to another person, but there may be tax consequences.

If an annuity is assigned to someone other than the original owner, the new owner will be taxed on the earnings in the annuity. The original owner will not be taxed on the earnings.

The tax consequences of an assignment depend on whether the annuity is a qualified or non-qualified annuity.

If the annuity is a qualified annuity, such as an IRA, the earnings in the account will not be taxed when they are withdrawn. If the annuity is a non-qualified annuity, the earnings in the account will be taxed when they are withdrawn.

Spouses

An annuity can be assigned to a spouse without triggering any tax consequences. An annuity cannot be assigned to a child or other dependent without triggering tax consequences.

Surrendering The Annuity

When an annuity is surrendered, the policyholder will owe taxes on the earnings in the account. The policyholder will also owe taxes on any contributions that were deducted from their taxes.

The tax consequences of surrendering an annuity depend on whether the annuity is a qualified or non-qualified annuity.

Inherited Annuity Taxation

An inherited annuity is an annuity that is passed down to a beneficiary after the death of the original owner.

The tax consequences of an inherited annuity depend on whether the annuity is a qualified or non-qualified annuity.

If the inherited annuity is a qualified annuity, such as an IRA, the entire amount in the account is taxable when withdrawn. If the inherited annuity is a non-qualified annuity, only the earnings in the account will be taxed when they are withdrawn.

If you are an annuity owner wanting to leave money to your beneficiaries tax-free, life insurance might be a better option for you. You don’t have to take a medical examination in some cases. Compare free life insurance quotes to find affordable coverage. Coverage starts at $9.37 per month.

Conclusion

Conclusion paragraph: If you are ready to purchase an annuity, it is important to understand the tax implications. Roth annuities are not taxable, so they may be a better option if you expect to be in a higher tax bracket when you start taking withdrawals. All other types of annuities are taxable, so you will want to factor this into your decision-making process. When you are ready, request a quote and one of our experts will help walk you through the process.

Annuity Taxes

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Frequently Asked Questions

During the payout period of an annuity, the interest portion of the payment is

During the payout period of an annuity, the interest portion of the payment is taxed as ordinary income. During the payout period of an annuity, the interest portion of the payment is taxed as ordinary income.

Are retirement annuities taxable?

Withdrawals from qualified annuities are taxed as ordinary income on the entire distribution. Withdrawals from non-qualified annuities are taxed as ordinary income on the earnings in the account. Income from a Roth annuity is tax-free.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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