Are Annuity Payments Considered Income?
While annuity payments are considered income, not all of it is necessarily taxed. Learn how your initial investment determines the taxable portion of your payments.
Annuity payments are considered income for tax purposes, but how they are taxed depends on several factors. An annuity is a contract with an insurance company where you make payments in exchange for a future stream of income. While all annuities offer tax-deferred growth, the taxation of payments hinges on whether the annuity was purchased with money that has already been taxed or with pre-tax funds.
The Foundation of Annuity Taxation
The principle for taxing annuities purchased with after-tax money is to separate each payment into two parts: a return of your investment and taxable earnings. You do not pay tax on the portion of the payment that is a return of the money you originally paid, known as the principal. The portion that represents interest or investment gains is subject to ordinary income tax. This separation is governed by a calculation known as the “exclusion ratio.”
The exclusion ratio is a formula used to determine the percentage of each annuity payment that is a tax-free return of your principal. To calculate it, you divide your total investment in the annuity contract by the total amount you are expected to receive. The resulting percentage is the portion of each payment you can exclude from your taxable income until your entire principal has been returned.
For example, imagine you purchase an annuity for $100,000. Based on actuarial tables, your total expected return is calculated to be $150,000. The exclusion ratio would be your investment ($100,000) divided by your expected return ($150,000), which equals 66.7%. This means for every payment you receive, 66.7% is a tax-free return of your principal, and the remaining 33.3% is taxable.
Once the total of all the tax-free portions you have received equals your original $100,000 investment, any subsequent payments you receive will be fully taxable. The Internal Revenue Service (IRS) provides tables and rules in publications like Publication 575 to help calculate the expected return based on life expectancy.
Tax Treatment of Non-Qualified Annuities
A non-qualified annuity is one you fund with after-tax dollars. The tax treatment for these annuities depends on how you receive the money: as periodic payments or as non-annuitized withdrawals. When you choose to annuitize the contract and receive systematic payments, the exclusion ratio is applied to each payment, splitting it into a tax-free return of principal and a taxable earnings portion.
The tax rules are different for non-annuitized withdrawals, such as partial cash-outs or a full lump-sum surrender. These distributions are taxed on a Last-In, First-Out (LIFO) basis. Under the LIFO method, the IRS considers the first money you withdraw from the contract to be earnings. All withdrawals are fully taxable as ordinary income until you have taken out all the accumulated gains.
After all the earnings have been withdrawn and taxed, you can begin to access your original principal contributions tax-free. For instance, if you invested $100,000 in a non-qualified annuity that has grown to $150,000, the first $50,000 you withdraw will be fully taxable. Any subsequent withdrawals beyond that amount would be a tax-free return of your principal.
Any taxable withdrawals taken before you reach age 59 ½ may also be subject to a 10% early withdrawal penalty from the IRS, in addition to the ordinary income tax.
Tax Treatment of Qualified Annuities
Qualified annuities are those held within a tax-advantaged retirement account, such as a Traditional IRA, 401(k), or 403(b) plan. These annuities are funded with pre-tax dollars, meaning you have not yet paid any tax on the money inside the annuity.
Every payment you receive from a qualified annuity is 100% taxable as ordinary income. There is no exclusion ratio or tax-free return of principal because the entire amount has never been taxed. The tax rules of the retirement plan itself, like a 401(k) or IRA, govern the annuity’s taxation.
Distributions from qualified annuities are also subject to the same age-related restrictions as the retirement accounts that hold them. If you take a distribution before reaching age 59 ½, the withdrawal is subject to a 10% early withdrawal penalty on top of the regular income tax owed. Some exceptions to this penalty exist, such as for disability or certain medical expenses.
Reporting Annuity Income on Your Tax Return
When you receive payments from an annuity, the insurance company will send you IRS Form 1099-R. You should receive this form by January 31 of the year following the distribution.
Box 1 of Form 1099-R shows the gross distribution, which is the total amount you received. Box 2a shows the taxable amount of the distribution. For a qualified annuity, this amount will be the same as Box 1. For a non-qualified annuity, this box will show the earnings portion of your payments calculated using the exclusion ratio.
Box 7 contains a distribution code that tells the IRS about the nature of your withdrawal.
- A code ‘7’ indicates a normal distribution.
- A code ‘1’ signifies an early distribution where you may be subject to the 10% penalty.
- A code ‘4’ denotes a death benefit.
- A code ‘6’ is used for a tax-free 1035 exchange to another annuity.
You will report the total annuity payments on lines 5a and 5b of Form 1040. Line 5a is for the gross distribution from Box 1 of Form 1099-R, and line 5b is for the taxable portion of that distribution from Box 2a.