Annuities Taxation: What You Need to Know

An annuity is a contract you purchase from an insurance company designed to provide you with income. You pay a premium, and in return, the insurer agrees to make regular payments back to you for a specified period or for life. This structure makes annuities a consideration for retirement planning. The primary appeal is their tax-deferred nature, meaning investment earnings can grow without being taxed annually. The tax treatment of the money you receive depends on several factors that determine when and how much tax you will owe.

Qualified vs Non-Qualified Annuities

The tax implications of an annuity hinge on whether it is classified as qualified or non-qualified. This classification is determined by the source of the funds used to purchase the contract—either pre-tax or after-tax dollars.

A qualified annuity is funded using pre-tax dollars. These annuities are typically purchased within an employer-sponsored retirement plan, such as a 401(k), or through a traditional Individual Retirement Arrangement (IRA). For example, when you retire, you might roll over your 401(k) balance into a qualified annuity.

In contrast, a non-qualified annuity is purchased with after-tax dollars from a personal savings account. Because the initial investment, or principal, has already been taxed, it creates what is known as the “cost basis” in the contract. This cost basis is the amount you can receive back from the annuity without paying taxes on it again.

This difference directly impacts how distributions are treated by the IRS. For qualified annuities, since neither the investment nor the earnings have been taxed, all payments you receive are taxable. For non-qualified annuities, only the earnings are subject to tax.

Taxation of Annuity Distributions

The taxation of money withdrawn from an annuity depends on its qualified or non-qualified status. For non-qualified annuities, the tax rules vary based on how you receive the funds, whereas the rules for qualified annuities are more direct. An additional penalty may also apply for early withdrawals from either type.

Taxation of Non-Qualified Annuity Payments

When you begin receiving regular, scheduled payments from a non-qualified annuity, a method called the “exclusion ratio” is used to determine the tax on each payment. This calculation separates each payment into two parts: a tax-free return of your principal (your cost basis) and taxable income (the earnings). The insurance company paying the annuity typically calculates this for you.

To illustrate, assume you purchased a non-qualified annuity for $100,000 and are expected to receive a total of $150,000 in payments. Your exclusion ratio would be 66.7% ($100,000 / $150,000). This means 66.7% of each payment is a tax-free return of your principal, and the rest is taxable. Once your entire $100,000 cost basis is returned, any subsequent payments will be fully taxable.

If you take withdrawals from a non-qualified annuity that are not part of a scheduled payout plan, the Last-In, First-Out (LIFO) rule applies. Under LIFO, the IRS considers taxable earnings to be withdrawn first, meaning initial withdrawals are fully taxable up to the amount of gain in the contract.

Taxation of Qualified Annuity Payments

The tax rules for qualified annuities are more straightforward. Because these annuities are funded with pre-tax dollars, you have no cost basis in the contract from your own taxed funds. As a result, the entire amount of every distribution you receive from a qualified annuity is subject to taxation as ordinary income. The income is taxed at your regular income tax rate for the year in which you receive it, similar to distributions from other pre-tax retirement accounts like traditional IRAs or 401(k)s.

Early Withdrawal Penalties

If you withdraw funds from an annuity before age 59 ½, you will likely face a 10% IRS penalty tax in addition to regular income tax. This penalty applies only to the taxable portion of the withdrawal.

For a qualified annuity, the penalty applies to the entire withdrawal since it is all considered taxable income. For a non-qualified annuity, the penalty applies only to the earnings portion of the withdrawal. Certain exceptions to this penalty exist, such as in cases of disability or death.

Taxation for Beneficiaries

When an annuity owner dies, the tax implications for the beneficiary depend on their relationship to the owner and whether the annuity is qualified or non-qualified.

If the beneficiary is the surviving spouse, they typically have the option of “spousal continuation.” This allows the spouse to take over the contract and continue it as their own, maintaining its tax-deferred status. Taxes are then due only when the surviving spouse takes withdrawals.

For non-spouse beneficiaries inheriting a non-qualified annuity, they generally have several options. They can take a lump-sum distribution, which makes all earnings taxable in one year. Alternatively, they can use the “five-year rule,” withdrawing the full balance over five years, or they may be able to “stretch” payments over their own life expectancy. Under these options, the original owner’s cost basis is returned tax-free, and only the earnings are taxed.

The rules for inheriting a qualified annuity are stricter. For most non-spouse beneficiaries, the SECURE Act of 2019 eliminated the stretch option. These beneficiaries are now generally required to withdraw the entire balance of the annuity by the end of the 10th year following the original owner’s death. All distributions are fully taxable as ordinary income.

Tax-Free Annuity Exchanges

Annuity owners may find that their existing contract no longer meets their needs, perhaps due to high fees or better available products. The Internal Revenue Code allows for the replacement of one annuity contract with another without immediately triggering taxes. This transaction is known as a Section 1035 exchange.

A 1035 exchange permits the direct transfer of funds from an existing annuity to a new one, preserving the tax-deferred status of the investment. For the transaction to be tax-free, the funds must be moved directly from the old insurance company to the new one.

To qualify, the exchange must be for a “like-kind” property, meaning an annuity for another annuity. The rules also require that the owner and annuitant on the new contract be the same as on the old one. The cost basis from the original annuity carries over to the new annuity, and the primary benefit is the ability to move to a better product while continuing to defer taxes on accumulated earnings.

Reporting Annuity Income

When you receive distributions from an annuity, the paying institution is required to report this information to both you and the IRS. This is done using Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” You will receive this form by the end of January for any distributions made during the previous calendar year.

Form 1099-R provides the specific details you need to accurately report your annuity income on your federal tax return. Box 1 of the form shows the gross distribution, and Box 2a shows the taxable amount. The gross distribution from Box 1 is reported on line 5a of Form 1040, and the taxable amount from Box 2a is reported on line 5b. This taxable amount is then included with your other income to determine your total tax liability for the year.

It is important to verify the information on Form 1099-R. If you believe the taxable amount reported by the payer is incorrect, you should contact them to resolve the discrepancy. Proper reporting ensures you pay the correct amount of tax and avoid potential issues with the IRS.