Are You Taxed on Annuity Income? The Tax Rules
Demystify annuity taxation. Understand how federal rules impact your annuity income, from contributions to distributions.
An annuity represents a contractual agreement with an insurance company, structured to provide a consistent stream of income, often utilized during retirement. Its tax treatment is not uniform, influenced by several factors. Understanding these determinants is important for effective financial planning, as tax implications can significantly affect net income.
Fundamental Tax Principles
Annuity income taxation differentiates between the principal (cost basis) and accumulated earnings. The principal, or original contribution, is typically returned tax-free. Only the earnings, which are the investment growth, are generally subject to income tax.
For regular, periodic annuity distributions, the Internal Revenue Service (IRS) uses an exclusion ratio to determine the taxable and non-taxable portions. This ratio divides the investment (principal) by the total expected return. The resulting percentage is the tax-free return of principal, with the remainder being taxable earnings.
For non-annuitized withdrawals from deferred non-qualified annuities, the Last-In, First-Out (LIFO) rule applies. Under LIFO, withdrawals are first considered earnings, making them fully taxable as ordinary income. This continues until all accumulated earnings are withdrawn. Only after earnings are exhausted are subsequent withdrawals treated as a tax-free return of principal.
Taxation of Qualified and Non-Qualified Annuities
The source of funding impacts how annuity income is taxed, categorizing annuities as non-qualified or qualified. Non-qualified annuities are funded with after-tax dollars. For these, the exclusion ratio applies to annuitized payments, and the LIFO rule applies to non-annuitized withdrawals.
Conversely, qualified annuities are funded with pre-tax dollars, typically within tax-advantaged retirement accounts like IRAs, 401(k)s, or 403(b)s. Since contributions were tax-deferred, there is generally no cost basis to exclude. Distributions from qualified annuities are usually 100% taxable as ordinary income.
Tax Implications of Distribution Methods
The method chosen for receiving annuity funds directly influences the associated tax consequences. When an annuity is annuitized, meaning regular, periodic payments are received for a specified period or for life, the exclusion ratio determines the tax-free and taxable portions for non-qualified annuities. Each payment includes a portion of the original principal, which is tax-free, and a portion of the earnings, which is taxable. For qualified annuities, however, these annuitized payments are typically fully taxable as ordinary income since the initial contributions were made with pre-tax dollars.
Taking a lump sum withdrawal from an annuity also carries distinct tax implications. For non-qualified annuities, the entire gain, or accumulated earnings, becomes taxable at once. If the annuity is qualified, the entire lump sum amount is generally taxable as ordinary income, unless it originated from a Roth account where contributions were made with after-tax dollars. Partial withdrawals from deferred non-qualified annuities are subject to the LIFO rule, meaning earnings are considered withdrawn first and are fully taxable until all earnings have been depleted. For qualified annuities, partial withdrawals are fully taxable.
Annuity contracts may include various riders and features, such as income riders or guaranteed withdrawal benefits. These features can alter the calculation of the taxable portion of distributions. The specific terms of these riders dictate how they might affect the amount considered earnings versus principal for tax purposes.
Other Important Tax Considerations
Distributions taken from an annuity before the owner reaches age 59½ may be subject to a 10% early withdrawal penalty on the taxable portion, in addition to regular income taxes. Common exceptions to this penalty include distributions made due to the annuitant’s death, disability, or if payments are part of a series of substantially equal periodic payments.
The taxation of annuity death benefits paid to beneficiaries also varies. A surviving spouse, as a beneficiary, often has the option to continue the contract as their own, thereby deferring taxation. Other beneficiaries typically face different payout and tax options, such as receiving a lump sum, which can trigger immediate taxation of earnings, or spreading payments over a five-year period. For qualified annuities, beneficiaries generally inherit the tax-deferred status, but distributions remain fully taxable.
A 1035 exchange allows for the tax-free transfer of funds from one annuity contract to another, or from a life insurance policy to an annuity. This provision enables policyholders to switch contracts without incurring immediate taxation on accumulated gains. However, while the exchange itself is tax-free, the original cost basis and accumulated earnings carry over to the new contract, meaning future distributions from the new annuity will still be taxed according to the original contract’s characteristics. Additionally, while federal tax rules are primary, state income tax laws can also apply to annuity income, further influencing the overall tax liability.