What Are the Tax Benefits of an Annuity?

An annuity is a contract between an individual and an insurance company, structured to provide income, often during retirement. Its purpose is to create a steady stream of payments for a specified period or for the remainder of a person’s life. This process involves two distinct phases, starting with the accumulation phase, where the individual funds the annuity through a lump-sum payment or a series of contributions.

Following the accumulation phase is the payout, or annuitization, phase, where the insurance company makes regular payments back to the individual. The structure of these payments can vary based on the contract’s terms, with options for fixed payments or payments that fluctuate based on investment performance.

The Core Benefit of Tax Deferral

Annuities offer tax-deferred growth, setting them apart from many investment vehicles. In a standard brokerage account, taxes may be due annually on any interest, dividends, or capital gains generated. This annual tax liability reduces the net return and slows the compounding effect on the investment’s growth.

With an annuity, earnings are not taxed each year; taxes are postponed until the money is withdrawn. This allows the investment to grow unimpeded by annual tax payments. This tax-deferred environment means earnings can be reinvested in their entirety, accelerating growth through more powerful compounding.

To illustrate, consider a $50,000 investment. In a taxable account earning 6% annually, assuming a 24% tax rate on the gains, the net growth is reduced each year. Over 20 years, the value might grow to approximately $120,000. In a tax-deferred annuity with the same 6% growth rate, the entire gain is reinvested each year. After 20 years, that same $50,000 could grow to over $160,000 before any taxes are assessed upon withdrawal.

Qualified vs Non-Qualified Annuities

An annuity’s tax treatment is determined by the source of the funds used to purchase it, leading to two classifications: qualified and non-qualified. This classification does not relate to the quality of the annuity itself but strictly to the tax status of the money used for its purchase.

A qualified annuity is funded with pre-tax dollars, meaning the contributions are made from money that has not yet been subject to income tax. These annuities are part of tax-advantaged retirement plans, such as a traditional IRA, 401(k), or 403(b). Because the contributions were not taxed, the entire value of the annuity—both principal and earnings—is subject to ordinary income tax upon withdrawal.

Conversely, a non-qualified annuity is purchased with after-tax dollars from a source like a personal savings account. Since the principal amount was already taxed, it will not be taxed again when withdrawn. For non-qualified annuities, only the accumulated earnings are subject to taxation.

Taxation of Withdrawals and Payments

For non-qualified annuities, the tax rules are designed to tax only the growth. When taking lump-sum withdrawals, the Internal Revenue Service (IRS) applies a Last-In, First-Out (LIFO) approach. This rule dictates that taxable earnings are considered to be withdrawn first. For example, if an annuity has $100,000 of after-tax principal and $30,000 in earnings, the first $30,000 withdrawn is fully taxable.

When you receive scheduled payments from a non-qualified annuity, the “exclusion ratio” is used. This calculation determines what portion of each payment is a tax-free return of your principal and what portion is taxable earnings. The ratio is found by dividing your total investment by the total expected return. If your $100,000 principal is expected to result in $150,000 of payments, two-thirds of each payment is a tax-free return of principal.

For qualified annuities, the tax situation is more straightforward. Since neither the contributions nor the earnings have been taxed, 100% of every withdrawal or payment is treated as ordinary income and is fully taxable.

A 10% federal tax penalty may apply to the taxable portion of any distribution taken before the owner reaches age 59 ½. This penalty is in addition to any ordinary income tax due. Exceptions for penalty-free withdrawals include the death or disability of the owner.

Tax Rules for Inherited Annuities

When an annuity owner passes away, the tax implications for the beneficiary depend on their relationship to the deceased and the choices they make. A surviving spouse who inherits an annuity has the most flexibility. A spousal beneficiary can often choose to treat the annuity as their own, continuing the contract and maintaining its tax-deferred status.

For non-spousal beneficiaries, the SECURE Act created a category of “Eligible Designated Beneficiaries” (EDBs). This group includes the owner’s minor children, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the owner. EDBs can take distributions over their own life expectancy, which spreads the tax liability over many years.

Most other non-spousal beneficiaries inheriting a qualified annuity are subject to a 10-year rule. If the owner died before starting required minimum distributions (RMDs), the beneficiary must withdraw the entire balance by the end of the 10th year. If the owner died after starting RMDs, the beneficiary must take annual distributions for nine years and withdraw the rest in the 10th year.

Taking a lump-sum distribution is an option for any beneficiary, though it requires paying income tax on the taxable portion in a single year. For non-qualified annuities, beneficiaries may also have options like the five-year rule or taking payments over their life expectancy, depending on the contract.

Tax-Free 1035 Exchanges

A Section 1035 exchange allows for the transfer of funds from one annuity contract to another without creating a taxable event. This rule permits individuals to move to a different annuity without first withdrawing funds and paying taxes on the gains. The tax-deferred status of the original investment is preserved and carried over to the new contract.

For the exchange to qualify as tax-free, the funds must be transferred directly from the old insurance company to the new one. The annuity owner cannot receive a check and then use it to purchase the new contract, as this would be a taxable distribution. The ownership of the new annuity must also remain the same as the old one.

While a 1035 exchange avoids immediate taxation, the new annuity will have its own features and costs. It will also likely have a new surrender charge period, which could impose fees if funds are withdrawn within the first several years of the new contract. You should evaluate the terms of the new annuity to ensure the exchange aligns with your financial goals.