How Much Tax Do You Pay on an Annuity Withdrawal?

An annuity is a contract between you and an insurance company designed to provide income. You make payments to the company, and in return, they agree to make payments back to you at a later date. Understanding the tax implications of taking money out of your annuity is an important part of managing your financial resources. The tax treatment of a withdrawal depends on several factors, which this article will explore.

Determining the Taxable Portion of a Withdrawal

The first step in understanding the tax on an annuity withdrawal is to determine what portion of the money is considered taxable. This depends on whether the annuity is classified as qualified or non-qualified. This distinction dictates how much of your withdrawal will be subject to income tax, as each type has different rules based on the tax status of the money used to fund it.

A qualified annuity is purchased with pre-tax dollars, meaning you have not yet paid taxes on the money used to buy it. These are funded through transfers from other tax-deferred retirement accounts like a traditional 401(k) or a traditional IRA. Because neither the initial contributions nor the subsequent earnings have been taxed, 100% of any withdrawal from a qualified annuity is considered taxable income.

In contrast, a non-qualified annuity is funded with after-tax dollars, meaning you have already paid income tax on the money. For these annuities, only the earnings portion of your withdrawal is subject to tax. The amount you originally contributed, known as the cost basis, can be withdrawn tax-free since you already paid tax on it.

The IRS uses a specific rule to determine the order in which money comes out of a non-qualified annuity, known as the Last-In, First-Out (LIFO) method. Under LIFO, the earnings are always considered to be withdrawn first. Only after all the earnings have been distributed can you begin to withdraw your original, tax-free cost basis.

To illustrate, imagine you funded a non-qualified annuity with $100,000 of after-tax money, and it has grown to a value of $130,000, giving you $30,000 in earnings. If you decide to withdraw $40,000, the LIFO rule dictates the tax treatment. The first $30,000 of your withdrawal is considered the earnings and is fully taxable as ordinary income. The remaining $10,000 of the withdrawal is treated as a tax-free return of your original cost basis.

Calculating the Tax on Withdrawals

Once you have identified the taxable portion of your annuity withdrawal, the tax is calculated. The taxable amount is not subject to preferential capital gains tax rates. Instead, it is taxed at your ordinary income tax rates for the year of the withdrawal, meaning the funds are treated the same as your salary or wages.

The tax rate applied to the withdrawal depends on your total taxable income for the year, which includes the annuity distribution. A large withdrawal can increase your overall income, potentially pushing you into a higher marginal tax bracket. This could cause the annuity income to be taxed at a higher rate and may also cause a larger portion of your other income to be taxed at that higher rate.

For example, if your income places you in the 22% federal tax bracket, the taxable portion of your annuity withdrawal will also be taxed at 22%. If the withdrawal is large enough to push your total income into the 24% bracket, that portion of the annuity income will be taxed at 24%. In addition to federal income tax, state income taxes may also apply to the taxable portion of the distribution.

The Early Withdrawal Penalty

Separate from ordinary income tax, an additional penalty may apply to annuity withdrawals taken too early. The IRS imposes a 10% federal tax penalty on the taxable portion of a distribution if the annuity owner is younger than 59 ½. This penalty is calculated on top of any regular income tax due on the withdrawal.

For instance, if you are 50 years old and withdraw $20,000 in taxable earnings from your annuity, you would owe ordinary income tax on that amount. You would also face an additional 10% penalty of $2,000 ($20,000 x 10%). This penalty is reported and paid on your annual income tax return.

The tax code provides several exceptions that allow annuity owners to avoid the 10% early withdrawal penalty. The penalty does not apply to distributions made to a beneficiary after the owner’s death or if the owner becomes totally and permanently disabled. It is also waived for distributions that are part of a series of substantially equal periodic payments (SEPP) taken over your life expectancy. Further exceptions include:

• Withdrawals for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
• Distributions to an owner with a terminal illness.
• Certain distributions of up to $10,000 to victims of domestic abuse.
• Withdrawals of up to $1,000 for emergency personal expenses.

Reporting Annuity Withdrawals on Your Tax Return

When you take a distribution from an annuity, the insurance company or financial institution must report the transaction to you and the IRS. You will receive Form 1099-R, which provides the necessary details about your withdrawal for tax filing. This form is typically mailed by the end of January following the year of the distribution.

Form 1099-R contains several boxes that summarize the details of your withdrawal. Box 1 shows the gross distribution, which is the total amount you received. Box 2a reports the taxable amount as calculated by the payer. If the payer cannot determine the taxable portion, the “taxable amount not determined” box may be checked, and you will need to calculate it yourself.

Other important information on the form includes Box 4, which shows any federal income tax that was withheld from your distribution at the time of payment. Box 7 contains a distribution code that tells the IRS the nature of the withdrawal. For example, a code ‘1’ indicates an early distribution with no known exception, signaling that the 10% penalty may apply, while a code ‘2’ indicates an early distribution for which an exception applies.

The information from Form 1099-R must be transferred to your annual income tax return, Form 1040. The gross distribution from Box 1 and the taxable amount from Box 2a are reported on the lines for pensions and annuities. Any tax withheld, as shown in Box 4, is reported in the payments section of your Form 1040. If you are subject to the 10% early withdrawal penalty, you will also need to file Form 5329 to calculate and report the penalty.