How Are Annuities Taxed?
Taxes are a top retirement concern, and as annuities are the only financial vehicle that can pay a guaranteed lifetime income, you might wonder about annuities and taxes. To understand how annuities are taxed, you should first understand the different types of annuities and how they can be used.
Basic Annuity Types
There are a few basic types of annuities in the market today. It’s good to note that all annuities are capable of paying a guaranteed lifetime income. But some annuity kinds are better equipped to pay you lifetime income while others are stronger for growth.
That being said, these basic types of annuities are:
Fixed Annuity – A fixed annuity typically provides a guaranteed rate of growth for a specified period. The longer the term is for your fixed annuity, the higher that interest rate tends to be. So, it’s vital to select the company from which you buy an annuity carefully.
Fixed Indexed Annuity – A fixed indexed annuity offers growth potential that is tied to an underlying financial benchmark index. The annuity allows the contract holder to have their money earn interest, based on what the index does, without downside exposure.
Variable Annuity – A variable annuity allows someone to place money in various mutual fund-like accounts for investment purposes. Legally, it’s both an insurance policy and a security. However, a variable annuity does expose the annuity assets to the full risk of loss in the market.
IRS Status of Annuities
Annuities can be tax-qualified or non-qualified. They can be purchased in retirement accounts or held as free-standing contracts. The difference between qualified and non-qualified tax status is significant because it affects how annuities are taxed for income.
- Tax-Qualified – A tax-qualified annuity is a retirement savings plan funded with pre-tax dollars.
- Non-Qualified – A non-qualified annuity is a savings plan funded with after-tax dollars.
- Annuities in Roth IRAs – Income from an annuity held in a Roth IRA will be tax-free, thus allowing for the possibility of tax-free lifetime retirement income.
Factors Affecting Taxation of Annuities
One of the primary benefits of an annuity is that the annuity grows tax-deferred until you begin to withdraw funds. This tax deferral allows the money you put in the annuity to grow without being reduced by tax payments.
Tax-deferral doesn’t mean tax-free. By allowing your qualified annuity assets to grow more rapidly through deferring taxes, the government is simply deferring its receipt of tax payments until you begin to withdraw the money.
When you do begin to withdraw sums of money, they will be taxed as ordinary income. In other words, they won’t receive the benefit of capital gains treatment.
Various factors impact the tax treatment of annuities upon withdrawal. Most importantly, no matter how you take withdrawals, the single most important factor in the taxation of an annuity is its qualified or non-qualified status.
Withdrawals from a qualified annuity, which again are begun with pre-tax dollars, will taxed as ordinary income when you take them out.
These annuities are often started with money from a lump-sum distribution from a 401(k) account, a similar employer retirement plan with pre-tax contributions, or an IRA. The withdrawn funds will be fully taxable as income because you have paid no taxes on these funds.
However, if you held that same annuity in a Roth IRA or Roth 401(k), the withdrawals can be completely tax-free.
Withdrawals from a non-qualified annuity, funded with after-tax dollars, will be subject to an exclusion ratio for tax purposes. For a non-qualified annuity, you will pay taxes only on the earnings generated by the assets in the annuity.
The amount of your withdrawal that counts as earnings is determined by applying the exclusion ratio. The exclusion ratio defines the percentage of the withdrawal that isn’t taxed.
In other words, when you withdraw money from a non-qualified annuity, most of the money is presumed to be a return of the principal with which you purchased the annuity. The remainder is taxed as income.
The formula for the exclusion ratio is:
Original Investment in the Contract/Expected Return.
When the insurance company issues the annuity to a purchaser, it promises to pay a certain amount for a certain period. That leads to an implied rate of growth on the assets.
The difference between the amount invested and the amount needed to make the promised payments is the amount that will be taxed as income.
The exclusion ratio will expire if the principal in the contract is ever fully paid out. This occurs when the someone continues to receive payments beyond the actuarial life expectancy originally made on the annuity.
In other words, it happens when someone is receiving annuity payments and they live beyond the life expectancy that the insurance company used for that annuity contract. At that point, the full amount of the payments will be taxable.
Timing of Withdrawals
The timing of withdrawals can also impact your taxes on annuity payments. If you withdraw funds from your annuity before the age of 59.5, you will likely owe a ten percent penalty on the taxable portion of the withdrawal.
After that age, withdrawals of lump sums (rather than the regularly scheduled payments) will trigger taxes on the earnings. You must pay income taxes on the taxable portion of the lump sum.
You can also increase the taxation of annuity withdrawals by how you take money from your non-qualified annuity. If, for example, you take payments monthly, you will be in a certain tax bracket and pay taxes on the excluded payment in that bracket.
However, taking a lump sum puts you into a much higher tax bracket and creates a correspondingly higher tax rate on your excluded portion.
Taxation of Inherited Annuities
You may inherit an annuity and be concerned about the taxation of the funds in it.
Essentially, the same rules apply. If the annuity was started with post-tax dollars, it would be a non-qualified annuity, and the exclusion ratio applies. All withdrawn funds will be subject to income tax if the annuity was begun with pre-tax dollars.
Note that different rules apply to the taxation depending on whether the inheritor is the surviving spouse. A surviving spouse can choose to convert the annuity to their own and simply step into the existing agreement.
This procedure is known as a spousal continuation. The spouse may also take a lump-sum distribution or decline the annuity in favor of a named contingent beneficiary.
Sometimes an annuity will name a minor as the beneficiary. These can be used, for example, for special needs children. The minor won’t be able to directly access the money until the age of 18.
The Secure Act and Inherited IRAs
Some special rules often apply to inherited IRA annuities. This is due to the SECURE Act, which became federal law in 2019, making some changes to how inherited IRAs are treated.
Talk to your financial professional about the SECURE Act may affect the taxation of your IRA for your heirs. You are also welcome to contact us and ask for more basic information or be connected with an independent financial professional from SafeMoney.com.
Planning for Your Retirement Income Strategy
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