Do You Have to Pay Taxes on an Annuity?

Annuities are financial products designed to provide a steady stream of income, often utilized for retirement planning. They serve as a contract between an individual and an insurance company, where the individual makes payments and receives regular disbursements over a specified period or for life. While annuities offer predictable income and tax-deferred growth, understanding their tax implications is important.

Understanding Annuity Income Taxation

Annuities grow tax-deferred, meaning earnings within the contract are not taxed until withdrawn. When distributions begin, only the earnings portion is generally taxable. The return of the original principal, or “cost basis,” is not taxed again, as it was funded with after-tax dollars.

Non-Qualified Annuities

Non-qualified annuities are funded with after-tax money. For these, the “exclusion ratio” determines the non-taxable portion of each annuitized payment. This ratio calculates the percentage of each payment representing a return of original principal. The remaining portion, representing earnings, is subject to ordinary income tax. When withdrawals are made before annuitization, the “Last-In, First-Out” (LIFO) rule applies, meaning earnings are assumed to be withdrawn first and are taxed as ordinary income until exhausted.

Qualified Annuities

Qualified annuities are typically held within tax-advantaged retirement accounts like IRAs or 401(k)s. Contributions to these annuities are often made with pre-tax dollars or grow tax-deferred. Consequently, distributions from qualified annuities are generally fully taxable as ordinary income because no taxes were paid on the funds initially. Qualified annuities are also subject to Required Minimum Distribution (RMD) rules, meaning distributions must begin by age 73 for most individuals to avoid penalties.

Taxation of Specific Annuity Transactions

Beyond regular income payments, various transactions involving annuities trigger specific tax consequences. For instance, early withdrawals, typically before age 59 1/2, are generally subject to an additional 10% federal tax penalty on the taxable portion. This penalty applies to both qualified and non-qualified annuities, though for non-qualified annuities, it usually only applies to earnings. Exceptions include withdrawals due to the annuitant’s death or total and permanent disability.

Full Surrender

A full surrender, where the contract is terminated and a lump sum is received, results in any gain being taxed as ordinary income. The gain is calculated as the market value minus the original cost basis. For non-qualified annuities, this gain is subject to the LIFO rule, meaning earnings are taxed first.

Death Benefits

Annuity death benefits paid to beneficiaries are also subject to taxation. For qualified annuities, the entire death benefit is generally taxable as ordinary income to the beneficiary. For non-qualified annuities, only the earnings portion of the death benefit is taxable. Beneficiaries typically pay income tax on the taxable portion, whether received as a lump sum or periodic payments.

Section 1035 Exchange

A Section 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 permits individuals to update contracts or switch providers without immediate tax liability on accumulated gains. To qualify, the exchange must be a direct transfer between insurance companies, and the owner and annuitant must generally remain the same.

Reporting Annuity Income

Reporting annuity income for tax purposes primarily involves Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” Annuity issuers send this form to individuals who received distributions of $10 or more during the year.

Form 1099-R provides information for tax filing. Box 1 shows the “Gross Distribution,” the total amount distributed. Box 2a, “Taxable Amount,” indicates the taxable portion. Box 4 reports any federal income tax withheld. Box 7 contains a “Distribution Code” that specifies the distribution type, which helps determine its tax treatment. Taxpayers use this information to accurately report annuity income on their annual tax returns.