Are Annuities Taxable? It Depends

Are Annuities Taxable? It Depends

Are annuities taxable? It’s an important question if you are shopping for annuities with the goal of guaranteed income. An annuity can help us sleep better at night, knowing how much income the contract will provide each month and that it can last as long as we do.

But while guaranteed income may sound good, there is also the flip-side to consider. You may wonder about whether annuity contracts might pose a potential tax trap.

It’s smart to consider the topic. And why? Because taxes are a primary concern for people in retirement. While released in 2010, a survey by Lincoln Financial Group still has relevance today. 

The study of affluent retirees found that federal income taxes were their largest expense. Among the respondents—age 62 through 75 with annual household incomes greater than $100,000—taxes were their largest expense. The survey results show that nearly 1 of every 3 dollars a retiree spent went to taxes.

Good news, though. A 2016 article by the Center for Retirement Research suggests that a “tax time bomb” may not be inevitable for many retirees. However, that premise is based upon 2007 U.S. household taxpayer numbers crunched by the Hamilton Project.

And other research, like a 2014 study on middle-income household awareness of retirement tax issues by Bankers Life, shows that taxes could well be a considerable chunk of future retiree spending. 

All of which leads back to that question: How could throwing annuities into the mix affect a tax bill?

How are Annuities Tax-Treated?

The short answer? The tax rules for annuities vary. It depends on what type of annuity you have, where the annuity money came from, and how money is taken from the contract. 

Where Did the Annuity Funds Come From?

Before you start receiving income payouts from an annuity, you will want to understand what sort of tax treatment to which these payouts may be subject. Luckily for ease of understanding, all annuities fall into one of two categories: qualified or non-qualified annuity contracts.

Whether you are considering a fixed, fixed index, variable contract or any other form of annuity, it will be funded from either qualified or non-qualified money.

Buying an Annuity with Qualified Money

If you use pre-tax dollars, money that came from an IRA, a 403(b), or a defined-benefit pension, this would be considered pre-tax money that you have never paid taxes on. Those funds would carry tax-deferral status. Here’s something important to keep in mind, though.

Whether they continue to be tax-deferred will depend on whether you rolled over or withdrew the money you use to buy an annuity from your qualified retirement plan. In other words, if you withdraw funds directly and purchase an annuity contract, you will have to immediately cover taxes on that sum. On the other hand, rolled-over funds would keep their tax-deferral status.

Payouts from an annuity funded in this way would be considered qualified money. They would be subject to ordinary income tax rates when that money was withdrawn and received by you. It’s important to know that there are no additional tax advantages to using pre-tax dollars to buy a qualified annuity. The contract already comes with tax-deferred treatment under IRS rules. 

We already discussed some sources of qualified money, but here are some overall sources that are used to pay into annuities:

  • Traditional IRAs
  • SEP-IRAs
  • 401(k) accounts
  • 403(b) accounts
  • 457 plans
  • Thrift Savings Plan accounts (a federal retirement plan)

 A Penalty Tax for Early Withdrawal

Like all annuities, a qualified annuity is meant to serve as part of your financial planning for retirement. To discourage you from taking withdrawals from your qualified annuity contract before you turn age 59.5, the IRS levies a 10% income tax penalty for any withdrawals taken before you reach that age.

One important distinction between qualified and non-qualified annuities is that the government will make it obligatory for you to start withdrawing money from your qualified account once you turn 70.5. 

These withdrawal requirements are called “required minimum distributions.” The IRS will base the amounts you must withdraw annually on your life expectancy.

Non-Qualified Annuities Only Tax Interest Earned

Again, any type of annuity can have a non-qualified designation. With a non-qualified annuity, the premium is paid with money you have already paid income tax on. So, later on, when it’s time for you to withdraw your money, you will only be subject to paying interest earned in your contract.

The first withdrawals are considered to be from earned interest. Any remaining withdrawls are understood to be tax-free paybacks of your principal. And there is no limit on the amount of money you can put into a non-qualified annuity contract.

Moreover, the source of funds is not limited to income earned. Unfortunately, as with qualified annuities, you will incur a 10% income tax penalty from the IRS if you withdraw money before turning 59.5.

That said, the IRS will not require you to take withdrawals from your non-qualified annuities. Some ‘sources of funds’ for non-qualified annuities are:

  • Brokerage accounts
  • Bank savings accounts
  • Certificates of deposit
  • Bonds
  • Mutual fund accounts
  • Other taxable accounts

Roth Money Treated Differently

While a Roth IRA and a non-qualified source of money are similar in some ways, they are different. Under the IRS code, a Roth IRA is a retirement account with specialized tax treatment. While the account holder receives no tax deductions on their Roth IRA contributions, their earnings grow on a tax-free basis — instead of tax-deferred like they would in a traditional IRA.

This difference from a non-qualified money source is important because of potential tax implications. The proceeds from a Roth IRA would retain their tax-free status. So, using Roth IRA funds to buy an annuity means that payments from that annuity would receive the same tax treatment.

Another Important Distinction for Tax Purposes

Here’s another factor to keep in mind regarding the tax treatment of annuities. It also depends on whether you have an immediate annuity or a deferred annuity. An immediate annuity will start payouts to you right away — at the latest, 12 months past the issue date. 

With a deferred annuity, you may not see payouts until some years later.

Estimating the Taxable Portion of Your Annuity Payouts

If you buy an immediate annuity with non-qualified money, a portion of your annuity payments will be taxable. The remaining portion will be non-taxable. You may be wondering about how you can estimate this.

Enter the exclusion ratio. Say you purchased an annuity with dollars from a brokerage account. A certain proportion of every annuity payment you received would be treated as a payback of your principal.

The contract would have an exclusion ratio, and a portion of each of your annuity payouts wouldn’t be taxable. Since you were already taxed on the principal, the interest that you had already earned would be the only thing taxable. This can be a helpful strategy for tax efficiency in income planning, particularly if you will rely on significant streams of income in retirement.

Using the Exclusion Ratio to Calculate Your Taxable Annuity Payments

Here’s how the exclusion ratio of an immediate annuity is determined.

Take the total sum of after-tax dollars you paid into the annuity — or your principal — and divide it by the total amount of payments you expect to receive. The resulting percentage rate is your exclusion ratio. This percentage rate specifies the amount of each income benefit payment that is exempt from taxes. The remaining portion of the income payment would be taxable.

Let’s use some numbers in a hypothetical example to drive this home:

  • Someone puts $20,000 toward their immediate annuity contract.
  • Assume that their total payments per year will be $1,500 and their life expectancy is 20 years.
  • That would bring the total amount of payments we expect they will receive to $30,000.
  • Since the total amount of expected payments is $30,000, the annuity exclusion ratio for this immediate annuity is 66.7%.

This would mean that the non-taxable part of each income payment will be equal to 66.67% of $1,500, which comes to $1,000.50. 

Understand What Your Annuity Contract Specifies

Generally speaking, non-qualified annuities don’t have withdrawal requirements at any age. That said, some non-qualified annuity contracts themselves may include distribution requirements.

Non-qualified annuities from some insurance providers require forced annuitization or distribution. What happens to money left in the contract? Some annuities start forced income payments at a certain age, which generally ranges from ages 85 to 100.

Tax Treatment of Annuities is Only Part of the Picture

Having gone through this information, you may wonder about what the tax treatment of an annuity death benefit is. Because this is a lengthy subject, you can read our “Is an Annuity Death Benefit Taxable?” article here.

Understanding all the details of annuities under your consideration will ensure the one you choose meets the needs of your retirement plan…as well as your income needs and tax-related strategy in the future.

That said, the potential tax implications of an annuity are just one variable to consider. You should evaluate all annuity features, benefits, limits, risks, downsides, and costs before purchasing any contract.

Need Personal Annuity Guidance?

If you think annuities might make sense for you, considering working with a knowledgeable financial professional. You will want to search for someone who understands retirement and how the tax-characteristics of annuities can help — or hinder — your situation.

Should you be ready for personal guidance, financial professionals stand ready at to help you. Use our “Find a Financial Professional” section to connect with someone directly. If you need a personal referral, call us at 877.476.9723.

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