How Are Annuities Taxed? What You Need to Know

An annuity is a contract between an individual and an insurance company, designed to provide a stream of income, often for retirement planning. These financial products involve various tax implications depending on how they are funded and how distributions are taken. Understanding these tax rules is important for anyone considering an annuity. This article explains the different ways annuity income and transactions are taxed.

Fundamental Tax Principles for Annuities

Annuities offer a significant tax advantage known as tax-deferred growth. This means that any earnings, such as interest, dividends, or capital gains generated within the annuity contract, are not taxed annually. Instead, taxes are postponed until funds are withdrawn or payments begin. This deferral allows the money inside the annuity to compound more rapidly, as earnings are reinvested without being reduced by immediate taxes.

The taxation of annuity withdrawals differentiates between the “cost basis” and “earnings.” The cost basis refers to the portion of contributions made with after-tax dollars, representing the principal invested into the annuity. Earnings, conversely, are the investment growth accumulated within the annuity over time. Generally, only the earnings portion is subject to ordinary income tax upon withdrawal. The cost basis, having already been taxed, is returned tax-free.

For non-qualified annuities, funded with after-tax dollars, the Internal Revenue Service (IRS) applies the Last-In, First-Out (LIFO) rule for partial withdrawals made during the accumulation phase. This rule dictates that earnings are considered to be withdrawn first, before the cost basis. This means that initial withdrawals from a non-qualified annuity will be fully taxable as ordinary income until all accumulated earnings have been distributed. Once the earnings are exhausted, subsequent withdrawals represent a tax-free return of the original cost basis.

Taxation of Annuity Distributions

The tax treatment of annuity distributions varies significantly based on whether the annuity is qualified or non-qualified. This distinction primarily depends on how the annuity was funded.

Non-Qualified Annuities

Non-qualified annuities are purchased with after-tax dollars. When these annuities begin to pay out as regular, periodic payments, a portion of each payment is considered a tax-free return of the cost basis, while the remainder is taxable earnings. This allocation is determined by the “exclusion ratio,” calculated by dividing the investment in the contract (cost basis) by the total expected return from the annuity payments. For instance, if the exclusion ratio is 20%, then 20% of each payment is a tax-free return of principal, and the remaining 80% is taxable income. Once the entire cost basis has been returned, all subsequent payments become fully taxable as ordinary income.

For non-annuitized withdrawals or partial surrenders from non-qualified annuities, the Last-In, First-Out (LIFO) rule applies. Any amount withdrawn is first considered taxable earnings until all earnings within the contract have been depleted. Only after all earnings have been withdrawn will further distributions be treated as a tax-free return of the original cost basis.

Qualified Annuities

Qualified annuities are funded with pre-tax dollars, often through tax-advantaged retirement accounts such as Individual Retirement Accounts (IRAs) or 401(k)s. Because contributions to these annuities were made with pre-tax dollars, the entire distribution from a qualified annuity is generally taxed as ordinary income upon withdrawal. This includes both the original contributions and any accumulated earnings.

There is no cost basis to recover in qualified annuities, as the entire amount has not been previously taxed. Consequently, when distributions are received, the full amount is subject to income tax at the individual’s ordinary income tax rate. This tax treatment applies whether the distributions are taken as a lump sum or as periodic payments.

Taxation of Specific Annuity Events

Beyond regular distributions, specific events related to annuities also carry distinct tax implications. These events require careful consideration to avoid unexpected tax consequences.

Early Withdrawals

Early withdrawals from an annuity before the annuitant reaches age 59½ may incur an additional 10% federal tax penalty on the taxable portion of the withdrawal. This penalty applies to the earnings that are withdrawn and is in addition to regular income taxes. However, several exceptions exist, such as withdrawals due to the annuitant’s death or disability, or if the payments are part of a series of substantially equal periodic payments (SEPPs).

Death Benefit

When an annuity owner dies, the tax treatment of the death benefit depends on whether the annuity was qualified or non-qualified. For non-qualified annuities, beneficiaries generally pay income tax only on the earnings portion. The original cost basis is received tax-free by the beneficiary. For qualified annuities, because the entire amount was funded with pre-tax dollars, the entire value of the annuity is generally taxable to the beneficiary, similar to other inherited retirement accounts. The specific payout option chosen by the beneficiary, such as a lump sum or payments over time, can impact when these taxes are due.

1035 Exchange

A “1035 exchange” allows for a tax-free transfer of funds from one annuity contract to another, or from a life insurance policy to an annuity. This provision in Internal Revenue Code Section 1035 permits the exchange without triggering immediate taxation on accumulated gains. To qualify as a tax-free exchange, specific IRS rules must be followed, including that the contracts must be on the same life and the owner must be the same person. This allows individuals to switch annuity products without incurring a current tax liability on the growth.