When Do You Have to Start Taking Distributions From an Annuity?

Annuities provide a consistent income stream, often used in retirement. For individuals holding these contracts, understanding the precise timing of when distributions are required is a fundamental aspect of sound financial planning. This knowledge helps ensure compliance with tax regulations and optimizes the use of these savings vehicles.

General Rules for Annuity Distributions

Annuities held within tax-advantaged retirement accounts, such as individual retirement accounts (IRAs) or 401(k)s, are subject to Required Minimum Distributions (RMDs). These distributions represent the minimum amount that must be withdrawn annually to ensure taxes are eventually paid on the tax-deferred funds. The age when RMDs commence for annuity owners has changed due to recent legislation.

Initially, RMDs began at age 70½. The Secure Act 1.0, effective for those turning 70½ after December 31, 2019, shifted this age to 72. Most recently, the Secure Act 2.0 further increased the RMD age to 73 for individuals who turn 72 after December 31, 2022. For those born in 1960 or later, the RMD age will increase to 75.

The first RMD is due by April 1st of the calendar year following the year the annuity owner reaches their specified RMD age. For example, if an individual turns 73 in 2024, their first RMD must be taken by April 1, 2025. Subsequent RMDs are due by December 31st each year.

These rules ensure taxes are collected on tax-deferred funds within qualified accounts. Annuity payments from a qualified annuity count towards satisfying these RMD obligations. If the annuity payments themselves are less than the calculated RMD, additional withdrawals are necessary to meet the requirement.

Qualified and Non-Qualified Annuities

The distinction between qualified and non-qualified annuities significantly impacts when distributions are required. Qualified annuities are those held within tax-advantaged retirement plans, such as IRAs or 401(k)s, and are typically funded with pre-tax dollars. These annuities are subject to RMD rules, requiring distributions once the owner reaches the federally mandated age.

In contrast, non-qualified annuities are purchased with after-tax dollars and exist outside of traditional retirement accounts. They are generally exempt from RMD rules during the annuitant’s lifetime. This offers greater flexibility, as there is no mandated distribution age.

While non-qualified annuities do not have RMDs, the tax treatment of their distributions differs from qualified annuities. When withdrawals are made, only the earnings portion is subject to income tax, as original contributions were after-tax. This means the principal amount is returned tax-free.

Once a non-qualified annuity is annuitized, converting it into a regular payment stream, each payment typically includes both a tax-free return of principal and taxable earnings. The portion of each payment that is tax-free is determined by an exclusion ratio, which calculates the percentage of the payment that represents the return of the original investment.

Distributions from Inherited Annuities

The rules for distributions from inherited annuities vary significantly based on the beneficiary’s relationship to the deceased owner and whether the annuity was qualified or non-qualified. For annuities inherited from qualified plans, the Secure Act introduced the “10-year rule” for most non-spousal beneficiaries. This rule generally requires the entire annuity balance to be distributed by the end of the 10th calendar year following the original owner’s death.

There are specific exceptions to this 10-year rule for certain “eligible designated beneficiaries” (EDBs). EDBs may stretch distributions over their own life expectancy for more favorable tax treatment. These EDBs include:
A surviving spouse
A minor child of the original owner
A disabled individual
A chronically ill individual
Any individual who is not more than 10 years younger than the deceased owner

Spousal beneficiaries have the most flexible options when inheriting an annuity. A surviving spouse can roll the inherited annuity into their own IRA. This allows them to defer distributions until they reach their own RMD age. Alternatively, a spouse may opt to take distributions under the 10-year rule or stretch payments over their life expectancy.

For inherited non-qualified annuities, the Secure Act did not alter the payout rules for beneficiaries. Non-spouse beneficiaries may use either their life expectancy or the five-year rule for distributions. Any gain in the policy is generally distributed and taxed as ordinary income first.

Implications of Not Taking Required Distributions

Failing to take a Required Minimum Distribution (RMD) by the deadline can lead to significant IRS penalties. The penalty for not withdrawing the full RMD amount is an excise tax of 25% of the shortfall, not the entire account balance.

The Secure Act 2.0 reduced this penalty from 50% to 25%, effective for tax years 2023 and later. The penalty can be further reduced to 10% if the missed RMD is corrected in a timely manner, generally within two years.

An annuity owner or beneficiary who misses an RMD may request a penalty waiver from the IRS. To qualify for this relief, the individual must establish that the failure was due to reasonable error and demonstrate that steps are being taken to remedy the shortfall. This involves filing IRS Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts,” with a letter of explanation.