Do You Have to Pay Taxes on Annuities?

Annuities are contracts with insurance companies, designed to offer a stream of income, often during retirement. These financial products provide tax-deferred growth, meaning earnings accumulate without immediate taxation. The tax treatment depends on several factors specific to each annuity contract. Income received from annuities will become taxable at some point during distributions.

Taxation of Non-Qualified Annuities

Non-qualified annuities are funded with after-tax money, meaning contributions have already been taxed. Earnings within the annuity grow tax-deferred, accumulating without annual tax obligations until funds are withdrawn. This deferral allows the principal and earnings to compound more efficiently over time.

When distributions begin from a non-qualified annuity in the form of regular payments, a portion of each payment is a tax-free return of the principal, while the remaining part is taxable earnings. This allocation is determined by an “exclusion ratio,” calculated by dividing the original investment by the total expected return. This ratio establishes the proportion of each payment excluded from taxation, preventing double taxation on the original after-tax contributions. Once the initial investment has been recovered through these tax-free portions, all subsequent annuity payments become fully taxable as ordinary income.

For lump-sum withdrawals or when an annuity contract is surrendered, the tax treatment follows a “Last-In, First-Out” (LIFO) rule. Withdrawals are first considered distributions of tax-deferred earnings, taxed as ordinary income until all accumulated earnings are depleted. Only after all earnings are withdrawn and taxed will subsequent withdrawals be treated as a tax-free return of the original after-tax principal.

Distributions from a non-qualified annuity made before age 59½ may incur an additional 10% federal income tax penalty on the taxable portion of the withdrawal. This penalty aims to discourage the use of annuities as short-term savings vehicles. Exceptions apply, such as distributions due to the owner’s death or disability. Another exception is if distributions are part of a series of substantially equal periodic payments made over the owner’s life or life expectancy.

Taxation of Qualified Annuities

Qualified annuities are held within tax-advantaged retirement plans, such as Individual Retirement Accounts (IRAs) or 401(k)s. These annuities are funded with pre-tax contributions, meaning the money used to purchase them has not yet been taxed. Both contributions and earnings within a qualified annuity grow tax-deferred, similar to other assets held within these retirement accounts.

When distributions are taken from a qualified annuity, the entire amount received, including original contributions and accumulated earnings, is taxable as ordinary income. This is because no taxes were paid on the contributions. Every dollar withdrawn from a qualified annuity becomes part of the owner’s taxable income for that year.

Distributions from qualified annuities made before age 59½ face an additional 10% federal income tax penalty. Unlike non-qualified annuities where only earnings are penalized, this penalty applies to the entire taxable distribution. Exceptions include distributions after the owner’s death, due to disability, or as part of a series of substantially equal periodic payments.

Qualified annuities are subject to Required Minimum Distribution (RMD) rules once the owner reaches age 73. Owners must begin taking distributions from their qualified retirement accounts by a specific deadline each year. The purpose of RMDs is to ensure that taxes on deferred retirement savings are eventually paid. Failing to take the full RMD can result in a 25% penalty on the amount not withdrawn. The RMD age is scheduled to increase to 75 in 2033.

Taxation in Special Circumstances

The tax treatment of annuities can become more nuanced in specific situations, such as death benefits paid to beneficiaries. For non-qualified annuities, only the earnings portion of the death benefit is subject to income tax. For qualified annuities, the entire death benefit is taxable as ordinary income to the beneficiary. Beneficiaries have several options for receiving these funds, such as a lump sum, spreading payments over five years, or annuitizing the benefits over their lifetime, each with different tax implications.

A 1035 exchange allows for the tax-free transfer of funds from one annuity contract to another without triggering a taxable event. The primary purpose of a 1035 exchange is to defer taxation, not eliminate it, providing flexibility for annuity owners to switch contracts while maintaining the tax-deferred status. To qualify, the transfer must be direct from one insurance company to another, and the ownership of the new annuity contract must remain the same.

Changing ownership or assigning an annuity to another party can have distinct tax implications. If an annuity’s ownership is transferred, it can trigger immediate tax consequences for the original owner. Any gains in the annuity at the time of transfer may become taxable income to the original owner.