Are Annuities Taxable?
Written by
Andrew Lisa
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Emily Gadd
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Annuities are contracts with insurance companies that can minimize risk, provide steady retirement income and reduce taxes — reduce, but not eliminate.
Annuities are complex financial instruments and their tax implications can be equally intricate. This article will explain how the IRS treats the different kinds of annuities and what it means for those who rely on them for income in retirement.
How Are Annuities Taxed?
The primary tax benefit of annuities is that their balances can grow on a tax-deferred basis until the owner begins receiving payouts in retirement. This is true for all annuities, whether you receive distributions as regular payments from an income annuity or make withdrawals from an accumulation annuity.
There are different kinds of annuities — including fixed, variable and indexed — but they’re all classified under two broad categories: qualified annuities and non-qualified annuities.
Each receives different tax treatment, and the format of both will be familiar to anyone with a retirement account.
Annuities are similar to traditional retirement accounts in that they’re taxed differently depending on whether they’re funded with pre-tax dollars or after-tax dollars. Those funded with money that hasn’t yet been taxed are called qualified annuities. Those funded with money that has been taxed are called non-qualified annuities.
Qualified Annuity Taxation
People fund qualified annuities with money they’ve already paid taxes on. They’re purchased through qualified plans like 401(k) plans or SIMPLE IRAs and exist within those plans. Therefore, they’re governed by the tax rules that regulate those kinds of plans, which override otherwise applicable annuity tax rules.
The structure of qualified annuities might be similar to 401(k)s, but unlike standard employer-based retirement accounts, contributions to annuities don’t reduce your taxable income. Also, withdrawals and distributions are taxed as regular income, not at the lower long-term capital gains rate, which means the rate you pay is tied to your income tax bracket.
Since the funds have never been subject to taxation, you must pay taxes on the entire distribution you receive in retirement.
Also, qualified annuities are subject to the same required minimum distribution (RMD) rules as standard retirement funds, unless they’re part of Roth IRAs.
Non-Qualified Annuity Taxation
Non-qualified annuities are funded with after-tax dollars, which makes them similar to Roth accounts, but there are some differences here, as well. These annuities are not usually held within a retirement account and serve as stand-alone policies.
Another important distinction is that the IRS taxes only the distributions of gains and interest, not the principal, which the annuity holder already paid taxes on before funding the account. Interest or earnings within the annuity are distributed before the principal amount once you start taking distributions from a non-qualified annuity.
Unlike qualified annuities, non-qualified annuities are exempt from RMD guidelines.
It’s important to note that the IRS treats both kinds of annuities as retirement vehicles and, therefore, early withdrawals or distributions — those taken before 59 1/2 years old — could trigger tax penalties of 10% on the taxable portion of the withdrawal. However, there are several scenarios where the penalty is waived, including permanent disability and terminal illness.
The penalty also doesn’t usually apply if the annuity is paid for life.
What Is the Exclusion Ratio?
The so-called exclusion ratio is used to determine the non-taxable portion of annuity payments. This ratio is based on the amount of principal payments (money you paid into the policy) and total earnings — and it considers your life expectancy.
It’s calculated by dividing the total amount invested in the annuity by the expected return and multiplying the monthly benefit by the number of months in your life expectancy. It is only applicable to non-qualified annuities.
Example
If you bought a $200,000 annuity with a guaranteed payment of $1,000 per month for the next 20 years, you would divide the annuity amount by your monthly payout and then multiply by your life expectancy (in months). So you would divide $200,000 by $1,000 then divide that by 240 months. This gives you an exclusion ratio of 83.33% — meaning 83.33% of your payments are excluded from your taxable income for a duration of 240 months.
If you outlive the life expectancy of the annuity, then all future payments thereafter are considered 100% taxable.
Are Annuity Withdrawals Taxable?
While regular annuity payments are typically taxable, withdrawing funds from your annuity may trigger taxes as well. Since some annuities offer a lump-sum payment vs. monthly payments — the lump-sum is treated as taxable income.
But similar to a monthly payment plan, lump-sum withdrawals from your annuity are taxed based on whether it’s a qualified or non-qualified annuity. Withdrawals from a qualified annuity are all treated as taxable income, while withdrawals from a non-qualified annuity are taxed only on the earnings portion.
Note: If you withdraw funds from your annuity before age 59 ½, you may have to pay an additional 10% penalty on the taxable portion of your annuity.
Last-In-First-Out
When withdrawing funds, or outside of regular annuity payments, from a non-qualified annuity, the IRS uses the “last in, first out” rule for determining the taxable portion of your withdrawal. Since you typically fund the annuity upfront and earnings grow over time, you may end up paying taxes on all of your withdrawals until you’ve taken more than the total earnings amount. For example, if you have a $50,000 annuity that’s now worth $70,000 — the first $20,000 you withdraw from the annuity is fully taxable.
How Are Inherited Annuities Taxed?
If you inherit an annuity, payouts from the annuity are taxed the same as if you bought the policy. This means if you inherit the IRA or 401(k) account that an annuity is held within, it is considered a qualified annuity — and payouts are taxed as ordinary income. Conversely, if you inherit a non-qualified annuity, you’re subject to the same exclusion ratio and partly taxable (or fully-taxable) payouts from the annuity.
There are exceptions to many rules, though, so it’s a good idea to meet with a licensed tax professional that specializes in inherited financial assets to help you navigate the tax treatment of an inherited annuity.
How To Report Annuity Income on Your Tax Return
Once you start receiving payouts from your annuity, you’ll need to report these payouts on your annual tax return. If you receive a payout from your annuity over $10, your provider should give you a 1099-R form that details your annuity payments, as well as any amounts excluded from your taxable income for non-qualified annuities.
You’ll report your 1099-R income on your tax return, but determining the taxability of your annuity and how to file it properly may require working with a tax professional. You can use IRS Publication 575 for the details on how annuities are taxed.
Publication 575
IRS Publication 575 is a document that outlines the tax treatment of annuities — as well as pensions — and details how to report the distributions you receive from them. The IRS updates it at the start of every year. Find the latest version on the agency’s Publication 575 page.
It covers topics like:
- Calculating the tax-free portion of periodic annuity payments, including how to use a worksheet for qualified plan payments.
- Calculating the tax-free portion of nonperiodic payments from both nonqualified and qualified plans.
- When to plan for additional taxes on distributions, like the taxes on early distributions and excess accumulation.
- Using optional methods to calculate taxes owed on lump-sum distributions.
- Rolling over distributions from one retirement plan to another.
Publication 575 does not cover the taxation of non-qualified annuities, which instead are covered in Publication 939. Publication 575 also doesn’t cover the treatment of IRAs and tax-sheltered annuity plans, also called 403(b) plans.
FAQ
- How are annuities given favorable tax treatment?
- Most annuities defer taxes until retirement, allowing your annuity to grow in value without paying annual taxes on any interest or dividends earned within the policy. Non-qualified annuities also pay back your principal investment as part of your monthly payments -- allowing you to exclude a portion of your payment from your taxable income.
- How can I avoid paying taxes on annuities?
- If you want to avoid paying taxes on an annuity, you need to hold it in a Roth designated account. Roth accounts are funded with after-tax dollars, but unlike non-qualified annuities, distributions from a Roth account annuity are tax-free. But the Roth account must have been open for at least five years to qualify.
- Is annuity income taxable?
- For most qualified annuities, the payments are generally taxed as ordinary income. But payments from non-qualified annuities include a repayment of your principal investments--and those principal amounts are excluded from your taxable income. And any annuity payouts from a designated Roth account are tax-free in retirement (after age 59 ½).
Jacob Wade contributed to the reporting of this article.
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