To estimate how much you can actually spend from an annuity, it’s critical to understand the tax rules. We’ll outline some of the most important features to consider as you plan for the future.
What Is an Annuity?
An annuity is an insurance contract designed to help investors with long-term goals. These insurance products offer a variety of guarantees, such as lifetime income, and any earnings inside of an annuity contract are tax-deferred. In its most basic form, an annuity pays out income that lasts for a specified length of time—whether that’s 20 years or the rest of your life. That income stream can be helpful when you want to replace a regular paycheck after you retire. You can choose to save money in a “deferred annuity” years in advance of receiving income, or you can purchase an “immediate annuity” with a lump sum in exchange for a guaranteed stream of payments. That said, you don’t necessarily need to take income from an annuity. For example, deferred annuities allow you to deposit money into an annuity contract and decide when (if ever) to begin income payments. Immediate annuities, on the other hand, typically begin paying out income within 12 months of the purchase date.
Are Annuities Taxable?
The tax treatment of contributions, withdrawals, and income depends on several factors. We’ll dig into the details below, but first, it’s important to distinguish between qualified annuities, non-qualified annuities, and Roth accounts.
Qualified annuities: An annuity funded with pre-tax dollars is often a qualified annuity. For example, if your annuity is part of an employer-sponsored retirement plan like a 401(k) or a SIMPLE IRA, you may be able to make pre-tax contributions.Non-qualified annuities: Non-qualified annuities are generally funded with after-tax contributions. For example, if you write a check from your bank account to pay into an annuity (and it’s not an IRA), it is likely a non-qualified contract.Roth accounts: Depending on the type, these can be either qualified or non-qualified plans. Designated Roth accounts, such as a Roth 403(b) or Roth 401(k), may be available through your employer, or you can invest in a Roth IRA on your own. Either way, contributions are after-tax.
How Annuities Are Taxed
Any growth or earnings inside of an annuity are tax-deferred until you start receiving income from the annuity. But taxation on contributions and withdrawals depends, in part, on whether or not the contract is a qualified or non-qualified annuity.
Qualified Annuity Taxes
When using a qualified annuity (such as one in an employer’s retirement plan) or a traditional IRA, the contributions you make typically reduce your taxable income for the year in which you contribute. For example, pre-tax contributions to a 401(k) annuity can lower your taxable income. However, you must eventually pay taxes when you take distributions from pre-tax accounts. That money has never been taxed, and the IRS treats the entirety of those distributions as ordinary taxable income.
Non-Qualified Annuity Taxes
Contributions to a non-qualified annuity—essentially, one that is not in a retirement plan—are generally not tax-deductible. (If you’re contributing to a traditional IRA, see the prior section). Because the money you use to fund the annuity has already been taxed, you can withdraw your principal tax-free (early withdrawals may be subject to the IRS penalty tax and/or surrender charges). However, any earnings inside of the annuity contract will be taxed when they’re withdrawn. When taking a lump-sum distribution from a non-qualified annuity, the IRS treats the withdrawal as last-in-first-out (LIFO). Your contribution went in first, and the earnings were added later (or “last”), so the earnings are withdrawn first. As a result, distributions are fully taxable until you take out all of the earnings. After that, withdrawals of your “basis,” or your original contributions, come out tax-free. If you annuitize an annuity outside of a retirement plan (as opposed to making one or more self-directed withdrawals), your payments may be partially taxable. The IRS allows you to use an “exclusion ratio” to treat a portion of each payment as a tax-free return of your basis. The remainder of the payment is treated as earnings, which will be taxed as ordinary income. If payments continue long enough to use all of the principal, payments you receive thereafter become fully taxable.
Taxes on Annuities in Roth Accounts
If the annuity is in a Roth account, such as a Roth 401(k) or a Roth IRA, your contributions are included in your taxable income the year you make them. Because you’ve already paid taxes on those contributions, you’re not taxed on qualified distributions taken from the annuity—whether those are withdrawals or annuity payments. Qualified distributions are, generally, those made after you turn 59 ½ and the account has been open for five years. Since qualified distributions from Roth accounts are designed to be tax-free and annuities can deliver lifelong payments, an annuity in such an account can potentially deliver tax-free income for life.
Qualified annuity distributions are fully taxable.Lump-sum distributions (withdrawals) from non-qualified annuities are broken down into basis and earnings. The earnings come out (and are taxed) first, and the basis comes out after the earnings are exhausted.Annuitized contracts often stop making payments after the death of the annuitant (the person entitled to receive the annuity’s benefits). However, if a contract continues to pay income, the exclusion ratio rules remain the same.
Additional rules and opportunities may apply when you inherit an annuity. For example, you may be able to roll qualified assets over to an IRA, or you might be required to distribute the funds within a specific timeframe. Check with a CPA to learn about the requirements and avoid tax penalties.
