Tax control is one of the biggest benefits of owning an annuity, since you'll have plenty of time to plan for the exact date when you’ll pay taxes on your earnings. How your annuity is taxed depends on the type of annuity you own, as well as your age, income, and when you begin to take distributions.
You can fund a qualified annuity with pre-tax dollars, or a non-qualified annuity with post-tax dollars. Here’s how those two types of annuities differ.
How are qualified annuities taxed?
Qualified annuities are funded with pre-tax dollars, which are also called qualified funds. Most often, qualified annuities are held in retirement accounts, like a 401(k) or 403(b) plan through an employer, or an individual retirement account (IRA).
You won’t pay taxes on the funds you contribute to your annuity until you start to withdraw money. Once you withdraw funds, you’ll pay income taxes on each installment.
Required minimum distributions
Your required minimum distribution (RMD) is the minimum amount of money you must withdraw from your qualified annuity each year. The IRS imposes RMDs for qualified accounts such as traditional IRAs, 401(k) plans, 403(b) plans, and more.
Typically, you’ll have to start taking required minimum distributions from qualified annuities by the time you reach age 72. [1]
Early withdrawal penalties
Because of the tax advantages that come with qualified annuities, you’ll pay an extra penalty fee for early withdrawals while you’re under age 59 ½. If you make withdrawals before you reach this age, you’ll pay an additional 10% tax on top of income tax.
Rollovers
You can generally roll over a qualified annuity into an IRA or another qualified plan tax-free. [2] For example, if you have a qualified 401(k) plan through a previous employer, you could choose to roll over to a traditional IRA, rather than transferring the funds to a different 401(k) with a new employer.
However, if you roll over a qualified annuity into a Roth IRA, it will be subject to immediate taxation.
How are non-qualified annuities taxed?
Non-qualified annuities are funded with post-tax dollars, otherwise known as non-qualified funds. You can fund a non-qualified annuity with post-tax income, savings, an inheritance, or the sale of an asset.
Because you’ve already paid taxes on your contributions, when you start to receive income payments from your non-qualified annuity, you’ll only need to pay taxes on the interest earned. Typically, when you annuitize your contract, the principal and interest earned will be spread out over all of your payments so that you’ll only pay taxes on a portion of each installment you receive.
Exclusion ratio
Your exclusion ratio is the portion of your non-qualified annuity income that isn’t taxed, because the IRS considers it a return of the principal you initially invested. How to calculate your personal exclusion ratio depends on the type of annuity you own and your age. Generally speaking, you’ll divide the cost of your annuity by your expected return.
For instance, if you purchase an immediate annuity worth $300,000, you'll receive $1,500 per month, and your payout period is 20 years, you would divide $300,000 by $360,000 (the latter of which represents your $1,500 payout times 12 months per year times 20 years). Your exclusion ratio would then be 83% — which represents the portion of your contract’s principal that won't be taxed. Therefore, only 17% of your income payments would be taxable.
The IRS publication 939 has extensive resources and actuarial tables you can use to calculate your exclusion ratio based on the type of annuity you own and your payout period. [3]
Non-annuitized distributions & withdrawals
If you don’t choose to annuitize your entire contract and you make withdrawals instead of scheduled payouts, the tax implications differ.
Non-qualified annuity withdrawals are taxed using the last-in-first-out rule (LIFO), which essentially means that your interest earnings are taxed first. For example, if you earned $20,000 in interest over the course of your accumulation period, the first $20,000 of your withdrawals will be taxed.
After that, your withdrawals are considered a return of your principal, and they won’t be taxed. The tax burden is heavier in the early years when you first start taking withdrawals.
The LIFO rule also applies to any income you receive from an annuity through an income benefit rider.
1035 exchanges
Section 1035 of the IRS tax code says that certain life insurance products, annuities, and long-term care insurance products may be exchanged for a product of a similar nature tax-free. [4]
You can’t withdraw funds to buy a new policy, but you can roll over your current funds into a different contract. In this case, you could still have to pay surrender fees, depending on the insurance company that’s servicing your annuity, but it ultimately depends on the insurer and how long you’ve held the contact. But as long as you roll over your funds into another contract, it doesn’t count as taxable income — whereas withdrawing funds would be considered a taxable event.
What are the taxation rules for inherited annuities?
If you’re the beneficiary on an annuity, the options available to you will usually depend on whether you’re a spouse or non-spouse beneficiary — as well as whether the annuity was qualified or non-qualified. If it’s a qualified annuity, you may be able to roll over a portion of the annuity tax-free into another qualified retirement plan, or a Roth IRA.
You can also elect to receive a lump sum, or periodic payments set over a fixed number of years. If you’re not taking life expectancy payments from an annuity, you must withdraw the full amount before 10 years have passed since the original annuity owner’s death. [5]
When you start making withdrawals as a beneficiary, you’ll report the annuity income on your taxes just as you would from any other source. If it was a qualified annuity, you’ll pay taxes on the entire withdrawal — if it was non-qualified, you’ll only pay taxes on the interest.
How do you report annuity taxes?
Most often, you’ll report annuity income using a 1099-R form when you file your taxes, which is typically provided by the company servicing your annuity. [6]
If you want to learn more about how your annuity is taxed and the regulations, the IRS updates Publication 575 every year with up-to-date information about how to determine the tax-free portion of annuity payments, annuity rollovers, disability benefits, and more.
Tips for maximizing tax benefits on annuities
It’s important to be aware of the tax rules surrounding your annuity, so you can plan accordingly. For example, planning not to take withdrawals before age 59 ½ is one way to avoid paying the extra 10% tax.
You should also be mindful of your income tax bracket and how your annuity withdrawals count toward your taxable income, as they may affect your tax bracket.
If you’re not sure how to best use an annuity for its tax advantages, or which type is appropriate for you, you should talk to a financial advisor.
