Do You Pay Income Taxes on an Annuity?
The tax treatment of an annuity is determined by how it was funded and the way you take distributions. Explore the key principles for managing your tax liability.
Annuities serve as a financial product for retirement planning by offering a stream of income. The tax treatment of these products is a significant factor for individuals considering them as part of their financial strategy. The way an annuity is taxed depends on several factors.
The Core Tax Distinction for Annuities
The tax treatment of an annuity hinges on whether it is classified as qualified or non-qualified. This distinction is determined by the source of the funds used to purchase the annuity contract: pre-tax or after-tax dollars.
A qualified annuity is purchased using pre-tax dollars, often within tax-advantaged retirement accounts like a traditional 401(k) or a traditional Individual Retirement Account (IRA). Because the initial contributions were not taxed, the entire value of the annuity, including principal and earnings, is subject to ordinary income tax when distributed.
In contrast, a non-qualified annuity is funded with after-tax dollars, meaning the money used for the purchase has already been taxed. When distributions are taken, only the earnings or growth portion of the annuity is subject to income tax. The original principal, or cost basis, is returned tax-free.
This difference in funding source impacts the amount of taxable income in retirement. For example, if you contribute $100,000 of pre-tax money to a qualified annuity, the full amount of any future payments will be taxable. If you use $100,000 of after-tax savings for a non-qualified annuity, only the investment gains are taxed.
Taxation of Scheduled Annuity Payouts
Once an owner begins receiving scheduled payments, a process known as annuitization, the tax rules depend on the annuity type. For qualified annuities, 100% of every payment is taxed at the individual’s ordinary income tax rate. These annuities are also subject to Required Minimum Distribution (RMD) rules, with the starting age at 73, scheduled to increase to 75 for individuals born in 1960 or later.
The taxation of payouts from non-qualified annuities is more complex and involves the “exclusion ratio.” This mechanism separates each payment into a non-taxable return of principal and a taxable distribution of investment gains. This prevents the double taxation of the after-tax money used to purchase the contract.
The exclusion ratio is calculated by dividing the total investment (the cost basis) by the expected return. The expected return is the total amount the owner anticipates receiving over the life of the annuity, determined using IRS life expectancy tables. The resulting percentage represents the portion of each payment that is excluded from taxes.
For example, assume an individual invested $100,000 in a non-qualified annuity and their total expected return is $150,000. The exclusion ratio would be $100,000 divided by $150,000, which equals 66.7%. If their monthly payment is $1,000, then $667 is a tax-free return of principal, and the remaining $333 is taxable ordinary income.
Taxation of Withdrawals and Surrenders
Taking funds from an annuity before starting scheduled lifetime payments, or surrendering the contract for a lump sum, has distinct tax consequences. For non-qualified annuities, the IRS applies a Last-In, First-Out (LIFO) accounting method. This rule dictates that earnings are withdrawn first, meaning initial withdrawals are fully taxable as ordinary income until all growth is distributed.
Once all earnings have been withdrawn and taxed, subsequent withdrawals are a tax-free return of the original principal. This LIFO treatment differs from the exclusion ratio for annuitized payments, which blends principal and earnings in each payment.
Withdrawals made before the owner reaches age 59 ½ are subject to a 10% early withdrawal penalty from the IRS. This penalty is applied to the taxable portion of any distribution, on top of ordinary income tax. For a qualified annuity, the penalty applies to the entire withdrawal, while for a non-qualified annuity, it applies only to the earnings.
It is important to distinguish between taxes and surrender charges. Surrender charges are fees imposed by the insurance company for withdrawing money during a specified period after purchase. Income tax and any applicable penalties are calculated on the amount withdrawn before these fees are deducted.
Tax Implications for Beneficiaries
When an annuity owner dies, the tax implications for the beneficiary depend on their relationship to the owner and the type of annuity. The rules ensure that any tax-deferred earnings are eventually taxed.
A surviving spouse who is the sole beneficiary can use “spousal continuation.” This allows the spouse to assume ownership of the annuity contract and treat it as their own. This continues the tax-deferred status of the funds, postponing taxes until they begin receiving distributions.
Non-spousal beneficiaries face more restrictive rules. For deaths after 2019, most are required to withdraw the entire balance of the inherited annuity within 10 years. The tax treatment of these withdrawals depends on the annuity type; for a qualified annuity, all distributions are taxable, while for a non-qualified annuity, only the earnings portion is taxed.
An exception to this 10-year rule exists for “Eligible Designated Beneficiaries,” such as the owner’s minor children or disabled individuals. These beneficiaries may be allowed to take payments over their life expectancy. This “stretch” provision is not available to most non-spousal beneficiaries.