How Are Monthly Life Annuity Benefit Payments Treated?

A monthly life annuity is a financial product that provides a guaranteed stream of income for the remainder of your life. In exchange for a lump-sum payment or a series of payments, an insurance company contractually agrees to send you regular payments. This structure is designed to offer financial stability during retirement. The tax implications of these payments depend on the source of the funds used to purchase the annuity.

Identifying Your Annuity Type

The first step in understanding the taxation of your annuity payments is to determine whether you have a qualified or non-qualified annuity. A qualified annuity is funded with pre-tax dollars, meaning the contributions were made before any income tax was paid on them. These are typically part of an employer-sponsored retirement plan, such as a 401(k) or 403(b), or a Traditional Individual Retirement Arrangement (IRA). In contrast, a non-qualified annuity is purchased with after-tax dollars from a personal savings or checking account that has already been subject to income tax, and you did not receive a tax deduction for purchasing this type of annuity.

Treatment of Qualified Annuity Payments

The tax treatment for payments from a qualified annuity is straightforward because the annuity was funded with pre-tax money. The entire amount of each monthly payment is considered ordinary income and is fully taxable at your regular federal and state income tax rates.

The annuity provider will typically withhold taxes from your payments, though you may have the option to adjust the withholding amount by providing them with Form W-4P. If you receive these payments before reaching age 59½, you may also be subject to a 10% additional tax on early distributions, unless you qualify for an exception.

Treatment of Non-Qualified Annuity Payments

The tax rules for non-qualified annuity payments are different because you funded the contract with after-tax money. You are not taxed on the portion of the payment that is considered a return of your original investment, also known as the “cost basis.” Each monthly payment is divided into a tax-free return of your principal and a taxable portion representing investment earnings.

The Internal Revenue Service (IRS) uses the “Exclusion Ratio” to determine what percentage of each payment is excluded from taxation. The calculation is based on your total investment in the contract and your “expected return.” The expected return is the total amount you are projected to receive over your lifetime, determined by IRS actuarial tables.

Calculating the taxable portion begins with determining your investment in the contract, which is the net cost of the annuity. This includes total premiums paid minus any tax-free withdrawals received before payments started. Next, you find your expected return using the tables in IRS Publication 939, “General Rule for Pensions and Annuities,” which provide a life expectancy multiple based on your age.

The exclusion ratio formula is your investment in the contract divided by your expected return. For example, if your investment was $160,000 and your expected return is $200,000, your exclusion ratio is 80%. If you receive a $1,000 monthly payment, $800 is a tax-free return of principal, and the remaining $200 is taxable income.

This exclusion ratio remains fixed for the life of the annuity. Once the cumulative tax-free portions of your payments equal your total investment in the contract, any subsequent payments you receive are fully taxable as ordinary income.

Reporting Annuity Income on Your Tax Return

At the end of the tax year, the financial institution that pays your annuity will send you Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form reports the total amount of the distributions you received during the year. Box 1 shows the gross distribution, while Box 2a shows the taxable amount; for qualified annuities, these two amounts will typically be the same.

For non-qualified annuities, the payer may calculate the taxable amount for you, or Box 2b may be checked, indicating that the taxable amount has not been determined. In this case, you are responsible for calculating the taxable portion and reporting the gross distribution on line 5a of Form 1040 and the taxable amount on line 5b.