How Are Annuities Taxed?

Shawn Plummer

CEO, The Annuity Expert

Wondering how annuities are taxed since they are tax-deferred retirement plans? Are annuities taxable? This guide will go over the various methods; annuity contracts are taxed.

Question Answered:

  • How are annuities taxed when distributed?
  • What is the tax consequence of amounts received from a traditional ira?
  • Withdrawals from a non-qualified annuity that is not part of an annuitization are taxed on which of the following methods?
  • How are qualified annuities taxed?
  • Qualified vs. Nonqualified annuity?

Are Annuities Taxable?

Is annuity income taxable? All income withdrawn from a qualified annuity plan (IRA annuity) is taxable and is taxed as ordinary income. All interest from nonqualified annuities is taxed as ordinary income. Income from a Roth IRA Annuity is tax-free as long as the IRS guidelines are met.

How to minimize taxes in retirement?

Convert traditional IRA into a Roth IRA via a Roth Conversion first. Maximize the annual Roth IRA contribution limits second since all income generated is tax-free. Third, maximize a nonqualified since only the interest is taxed. Finally, add a cost of living rider if seeking lifetime income to keep up with inflation over the years. Sales tax is unavoidable. The inflation benefit will help maintain the value of every dollar spent throughout retirement.

A long-term care annuity could provide a tax-free benefit to pay for nursing home expenses, home health care, or assisted living if one is seeking long-term care insurance.

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Taxes Affect Retirement Income Planning

Income taxation plays an important role in retirement income planning because it determines how much of your retirement you actually get to keep. To encourage taxpayers to save for retirement in

our government provides certain tax advantages.

The tax advantages include:

  • Exclusion of contributions to qualified plans and 403(b) plans
  • Possible deduction of contributions to traditional IRAs
  • Tax-deferred growth for many plans and nonqualified annuities
  • Potentially tax-free growth for Roth IRAs and Roth 401(k) designated accounts

The Internal Revenue Code also includes certain deterrents to ensure retirement dollars are used for retirement. Thus, it penalizes taxpayers who take retirement funds too early or too late.

Taxes on Annuities

Many rules for qualified and nonqualified annuities are similar. Yet, they are not the same.

Annuity tax is usually found in different Internal Revenue Code sections.

They can differ significantly.

It’s important to both understand them.

Qualified Annuity

If a retirement plan or annuity is qualified, an individual is saving for retirement with pre-taxed money. Since most qualified retirement plans are tax-deferred, all annuity withdrawals will be 100% taxable in the future .

Traditional IRAs

Each distribution from a Traditional IRA annuity is fully taxable.

If after-tax contributions have funded any of the individual’s traditional IRAs, then each distribution will be part taxable and part a return of basis.

The amount of any traditional IRA distribution that should be excluded from income during a taxable year is calculated using an annuity exclusion ratio.

The amount excluded is calculated by dividing the amount of nondeductible contributions not yet recovered by the sum of the total account balance as of year-end plus all distributions and any outstanding rollovers.

This amount is then multiplied by the amount of all distributions during the year. 

Distributions from traditional IRAs before age 59½ are subject to a 10 percent early distribution penalty unless an exception applies.

If no funds in a qualified plan or 403(b) annuity have already been taxed to the participant, the entire distribution is generally considered ordinary income.

Roth IRAs – Qualified Annuity

Taxation of a Roth IRA distribution depends on whether the distribution is qualified and, if not, whether the distribution amount is from regular contributions, conversion amounts, or earnings.

Generally, distributions of regular contributions to a Roth IRA are not taxable.

Qualified distributions from a Roth IRA are not includable in income or subject to the 10 percent early withdrawal penalty.

To be a qualified distribution, the distribution must satisfy two requirements, a holding period and a triggering event:

  • First, the distribution must occur after the fifth tax year for which a contribution was made to any Roth IRA owner.
  • Second, the distribution must satisfy one of four triggering events regarding the taxpayer:
    • becoming a first-time homebuyer ($ 10,000-lifetime limitation)
    • turning age 59½
    • becoming totally disabled
    • dying

If the distribution is made to a beneficiary after the owner’s death, the period held by the decedent is included in the period held by the beneficiary to determine whether the five-taxable-year period is satisfied.

A nonqualified distribution is defined as any distribution that is not qualified.

Nonqualified distributions from Roth IRAs are treated as made in the following order:

  • First, from regular contributions to the Roth IRA (regular contributions can be withdrawn tax- and penalty-free at any time).
  • Next from conversion contributions on a first-in-first-out (FIFO) basis. Thus, the distribution is treated as coming from the first converted amount that was includable in income and then from the nontaxable part, if any, of that converted amount (i.e., after-tax contributions). This process is repeated for each conversion in the order made.
  • Last from earnings on the regular Roth IRA contributions and conversions.

Like traditional IRAs, all of an individual’s Roth IRAs must be aggregated to apply the ordering rules.

Unless an exception applies, nonqualified distributions from Roth IRAs are subject to the 10 percent early distribution penalty to the extent that the distribution is includable in income.

The penalty may also apply in a nonqualified distribution attributed to an earlier conversion, even if the current distribution is not taxable.

This five taxable year holding period applicable to conversion contributions differs from the five taxable year period applicable to determining whether a Roth IRA distribution is qualified.

The five taxable year holding period applicable to conversion contributions begins in the taxable year of the conversion.

A new holding period begins with each conversion.

Nonqualified Annuities (Exclusion Ratio)

Nonqualified annuities are purchased with funds that were already taxed and can offer additional tax benefits.

The owner receives a tax basis in the annuity.

Basically, this means you pay taxes on any interest earned but not on any contributions you have made to the annuity.

Often referred to as the investment in the contract, it essentially equals total premiums paid (minus any amounts already received tax-free).

How that investment in the contract is recovered depends on whether the amount is considered an “amount received as an annuity” or an “amount not received as an annuity.”

Amounts not received as an annuity include:

  • Partial withdrawals, generally including systematic withdrawals, and
  • Loans, assignments, or pledges

These amounts are generally taxed on a last-in-first-out (LIFO) basis. As such, they are includable in income as ordinary income to the extent there is a gain in the contract.

Any interest earned will be distributed out of the annuity first (before your premium) therefore taxed on the gainable amount first.

Likewise, amounts received upon the complete surrender or redemption of an annuity are includable as ordinary income to the extent there is a gain in the contract.

However, if such payments are made in installments, the payments are not included in income until the contract’s investment has been fully recovered.

In determining the amount includable in income, all annuity contracts issued by the same insurance company to the same owner during any calendar year are treated as one contract.

Amounts received as an annuity generally refers either to annuity payouts under an immediate annuity or payouts from a deferred annuity contract annuitized. Investment in the contract is recovered pro rata from each payment.

An exclusion ratio is calculated by dividing the investment in the contract by the expected return.

Once the entire investment in the contract has been recovered, each annuity payment is taxed in full.

Annuitization Vs. Withdrawals

Lifetime withdrawals from an income rider and annuity payments from annuitizing your contract are 2 different methods of generating income from an annuity.

  • The exclusion ratio will be applied if you annuitize the contract.
  • LIFO (Last In, First Out) will be applied if you pocket lifetime withdrawals.

Last In, First Out (LIFO)

LIFO basically means any interest credited is applied to your annuity “Last,” and your original investment is applied to your annuity “First.” So with LIFO, your interest will come out first via withdrawals.

In a nutshell, you haven’t paid taxes on the interest you’ve earned thus far. So when you take income from your nonqualified annuity, the IRS wants the taxes paid on the interest first.

This means 100% of your retirement income (monthly, quarterly, semi-annual, or annual withdrawals) is 100% taxed until you’ve exhausted all of your gains from the annuity.

After you have exhausted all of your gains, your withdrawals are not taxable.

Taxation Of Annuity Plan Types

Taxation of Annuity Plan Types

Early Retirement Distributions

Distributions from:

  • qualified plans,
  • 403(b) plans,
  • IRAs and
  • nonqualified annuities

before age 59½ may be subject to an additional 10% penalty tax (25% in the case of SIMPLE IRAs in the first two years). The penalty tax applies to the amount includable in income. Some exceptions to the penalty exist. 

Early Retirement Penalty Exceptions

For example, *the immediate annuity exception does not apply to 1035 exchanges.

Surviving Spouses

A surviving spouse not yet 59½ should not execute a spousal rollover if there is any chance of needing the money before age 59½.

The exception for death is available only if the account remains in the name of the deceased owner.

Childbirth and Adoption

Early withdrawals (Up to $5,000 per individual) from qualified plans and IRAs for childbirth and child adoption are now exceptions to the 10% penalty rule.

Children under the age of 18 or mentally incapable of supporting themselves are eligible.

Children of other spouses are not included.

SOSEPP Exception to Early Retirement Distributions

In particular, one exception is a useful planning tool to eliminate the 10 percent penalty tax in cases where accessing funds before age 59½ cannot be avoided. It is the series of substantially equal periodic payments (SOSEPP) exception.

While often termed the 72(t) exception, exceptions to the penalty applicable to qualified plans, 403(b) plans, and IRAs are all found in IRC Section 72(t).

This exception is also found in Section 72(q), with the other exceptions applicable to nonqualified annuities.

Essentially, the SOSEPP exception provides that the early distribution penalty will not apply to any part of a series of substantially equal periodic payments made at least annually for:

  • the life or life expectancy of the individual or
  • the joint lives or joint life expectancies of the individual and their designated beneficiary

If the SOSEPP is modified before the latter of five years or age 59½, then the exception to the penalty is retroactively revoked.

In that event, a penalty and interest are owed for all payments made before age 59½.

SOSEPP Choices

The Size of the IRA

An owner can determine the IRA’s size from which to take the SOSEPP distributions using rollovers or trustee-to-trustee transfers.

The IRA aggregation rule does not apply to satisfy the SOSEPP exception.

IRAs can be split into smaller IRAs or combined into a larger IRA to achieve the desired payment.

Nonqualified annuities may not be as readily split or combined as the 1035 exchange rules must be satisfied.

The Method

The IRS provides three methods for determining periodic payment amounts:

RMD Method

Produces the smallest payment but is the easiest. Divide the account balance by the appropriate life expectancy factor from the

Payments are recalculated annually.

Amortization Method

Produces the largest payment.

The periodic payment is determined by amortizing the account balance in level amounts using a reasonable rate of interest and life expectancy from the

  • Single Life table
  • Joint and Survivor Life table or
  • Uniform Lifetime table.

Payments, once calculated, never vary.

Annuitization Method

Produces a payment slightly less than the amortization method.

The account balance is divided by an annuity factor derived using a specified mortality table and a reasonable interest rate.

Payments, once calculated, never vary.

When using either the amortization or the annuitization method, an owner or participant has a one-time option, in any year after the first year, of switching to the RMD method.

Modifications.

Payments can be modified after the later five years or age 59½.

Payments can then be reduced, increased, or stopped entirely.

Do not modify the SOSEPP  before the later of five years or age 59½, other than for death or disability.

The five-year period starts on the date of the first payment of the series and does not end until the fifth anniversary of the date of that first payment.

Therefore, DO NOT:

  • stop the payments early
  • take an extra payment
  • add to the amount in the IRA by contribution, rollover, or transfer

Post Retirement Distributions

Distributions from qualified plans and traditional IRAs must generally begin at age 72 or death, whichever comes first.

Distributions from Roth IRAs must begin upon the death of the owner.

Rules for these required minimum distributions (RMDs) are in IRC Section 401(a)(9) and its accompanying regulations.

Distributions from nonqualified annuities are not required during a lifetime but are required upon death.

Rules for required distributions from nonqualified annuities on the holder’s death are in IRC Section 72(s).

While the rules may be similar, key differences must be taken into account.

Traditional IRAs and Qualified Plans Distributions While Alive

Starting at a traditional IRA owner’s required beginning date (RBD), the entire interest in the IRA must be distributed to the IRA owner over the life of such owner or the lives of such owner and a designated beneficiary (or over a period not extending beyond the life expectancy of such owner or the life expectancies of such owner and a designated beneficiary).

The IRA owner’s RBD is April 1 of the year after the IRA owner turns age 72.

The rules are generally the same for participants in a qualified plan, except the participant’s RBD may be delayed if the participant continues to work past age 72 and holds a 5 percent or less ownership interest in the employer.

In that case, the RBD is April 1 of the year following the year the participant retires.

RMDs from IRAs and qualified plans not annuitized are calculated using the life expectancy method.

Using this method, the amount that must be distributed each year is determined by dividing the account balance as of December 31 of the prior year by a life expectancy factor taken from the appropriate table.

The appropriate table is the Uniform Lifetime table unless the account’s sole beneficiary is the owner’s spouse and the spouse is more than 10 years younger than the owner.

In that case, the correct table is the Joint and Survivor table.

It will produce larger factors and thus smaller RMDs.

The Uniform Lifetime Table is entered using the owner’s age as of December 31 of the distribution year.

The first distribution year is the year the owner attains age 72 (starting this year 2020).

The owner has until April 1 of the year following the year they attain age 72 to take their RMD for their first distribution year.

The RMD for every distribution year thereafter must be taken by December 31.

If the owner waits until April 1 of the following year (their RBD) to take their RMD for their first distribution year, they must take a second RMD by December 31 of that same year.

Caution*  If you turned age 70 1/2 before January 1, 2020, your RMDs are based on age 70 1/2, not age 72.

Qualified Plans, Traditional IRAs, and Roth IRAs Distributions After Death

How are inherited annuities taxed?

Annuity death benefits are taxable in most circumstances. However, the RMD rules applicable to either the IRA owner or plan participant’s death vary depending on when the IRA owner or plan participant dies and the designated beneficiaries.

Recently, The Secure Act eliminated the Stretch IRA which allowed designated beneficiaries to “stretch” their inheritance over their lifetime.

Now lifetime distributions from an inherited annuity are only eligible to designated beneficiaries that meet certain requirements, which are:

  • Spouses
  • Minors
  • The disabled or chronically ill
  • Beneficiaries less than 10 years younger

Designated beneficiaries can stretch their inheritance to 10 years in length.

Non-Designated beneficiaries can stretch their inheritance to 5 years in length or the participant’s remaining life expectancy.

The Stretch Act applies to

  • Deaths that occur after 2019
  • Beneficiaries already stretching (death occurred prior to 2020) are grandfathered
  • Qualified annuity contracts purchased and annuitized prior to 12/20/2019

Nonqualified Annuity Taxation After Death

Like the former RMD rules applicable on the death of the IRA owner or plan participant, distributions required on the death of the holder of a nonqualified annuity also vary by when the holder dies and the designated beneficiaries.

If the holder of a nonqualified annuity dies:

  • Before the annuity starting date (generally the first day of the first period for which an amount is received as an annuity), then the entire contract must be distributed within five years of the holder’s death — unless there is a designated beneficiary.
  • On or after their annuity starting date, the contract must be distributed at least as rapidly as under the method used by the holder — unless there is a designated beneficiary.

If there is a designated beneficiary, distributions may be made over the lifetime or life expectancy of the designated beneficiary as long as the distributions begin within one year of the holder’s death.

If the designated beneficiary is the holder’s surviving spouse, then the surviving spouse is treated as the contract holder.

Separate account rules apply when there are multiple designated beneficiaries under a nonqualified annuity contract, allowing each natural-person designated beneficiary to stretch out payments over their lifetime.

When an annuity contract holder is a non-natural person, such as a trust, the annuity holder is deemed the primary annuitant.

Thus, the death of the annuitant will trigger the required distributions.

If a trust is the beneficiary of the annuity contract, the longest period of time that the annuity death benefit payout can be deferred is five years from the annuitant’s date of death.

Note*  I am not a tax professional.  I am not giving tax advice.  This is for general knowledge only. Annuity taxation can be complex, and laws change all of the time.  Please seek a tax professional for further guidance.

Why you can trust The Annuity Expert

At The Annuity Expert, we strive to help you make confident financial decisions regarding annuities. Content provided is created by an independent licensed financial professional.

The Annuity Expert is an online insurance agency that provides the widest variety of annuities in the United States. When you buy an annuity directly from us, we receive a predetermined commission from the insurance company (not you). While your annuity is active, clients are not charged any servicing or management fees. Learn more.

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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