04 Jan How Annuities Are Taxed – What Every Investor Needs to Know
As with any investment vehicle, understanding how annuities are taxed before you invest in one is critical to your financial future.
If you’re not careful, you can take a heavy tax hit and end up paying way more in taxes than you originally planned for.
Keep reading for a breakdown of how annuities are taxed and what you need to know moving forward.
What Is an Annuity?
An annuity is a long-term contract between you and an insurance company.
It’s an investment vehicle where you put your money for a specified period of time, and, in return for your investment, you get income in the form of regular payments on a monthly basis, quarterly basis, or annual basis.
Or you can cash it out.
Annuities are typically used for retirement purposes to ensure you don’t run out of savings.
There are various types of annuities: fixed, fixed index, immediate, MYGA, variable, and SPIAS.
The type you select depends on what you’re looking for and what you want your money to do for you: generating lifetime income, saving for retirement, or leaving money to your family when you pass.
[Related Read: Types of Annuities Explained]
How Annuities Are Taxed
All annuities, no matter what type, grow tax-deferred – meaning that you don’t pay any taxes until you take a distribution (income payment) or make a cash withdrawal.
Annuities are taxed like other retirement plans.
When you make a withdrawal or cash out, it is taxed as normal income – not at a capital gains rate.
Exactly how much you pay is based on the type of annuity and how the account is set up in the beginning.
There are, however, two main taxation categories: qualified and non-qualified.
Understanding which one you have will make a big difference come tax time.
How Qualified Annuities Are Taxed
A qualified annuity is funded with pre-tax dollars, like an IRA or 401(k) rollover.
This means you will pay taxes as normal income in the year you take a distribution or cash it out.
It’s very similar to an IRA account.
Let’s say, for example, you take a $20,000 withdrawal. $20,000 will be added to your taxable income in the year that you have it distributed to you since no taxes have been paid on this money prior to this date.
Let’s say you make $60,000 this year, and you decide to take a one-time withdrawal or cash out the annuity.
That means that $20,000 will be added to your $60,000, which means you will be taxed on $80,000 of earned income when you pay taxes in April.
Because this is an IRA, the IRS will charge you a 10% penalty on any funds you take out prior to age 59½.
A Roth IRA, even though it is funded with after-tax dollars, is also considered a qualified annuity because it falls under the IRS tax guidelines for premature withdrawal penalties and taxes if you are under age 59½. More on that below.
How Non-Qualified Annuities Are Taxed
A non-qualified annuity is an annuity that you pay for or fund with after-tax dollars.
Non-qualified annuities are taxed differently than qualified annuities because you’re only taxed on the gains or the earnings since the contributions were already taxed.
So your money grows tax-deferred until you make a withdrawal – whether that be withdrawing regular payments, or a one-time withdrawal, or cashing it out.
To figure out the gains and determine how much is taxed, we use an exclusion ratio to figure out how much your payment, whether an income payment or a one-time cash payment distribution, is taxable and how much is not.
Basically, an exclusion ratio is the difference between your earnings and the amount of the principal paid.
Here’s how this works: Let’s say your principal payment into this non-qualified annuity with your after-tax dollars is $100,000. You let it grow tax-deferred for 10 years, and it’s now worth $150,000.
Your gains are $50,000.
Now, let’s say you want to take out $75,000 for a down payment on a home or to make a large purchase.
But, many people don’t realize that the IRS mandates that you take your interest out first. Many annuity holders just think, I’ll take out $75,000 of my principle and not touch my $50,000 in gains.
The IRS says, “You can take your $75,000, but the first $50,000, which is your gains, or interest, we’re going to tax that first.”
This is what’s called LIFO, or last in, first out.
The IRS is going to charge you first on your gains of $50,000, which will be taxable income in the year that you withdraw it.
The additional $25,000 from the principle is not taxed because it has already been taxed.
You’ll get a 1099 from the annuity company showing a distribution of $75,000 from this account. Right below it, it will show the taxable portion of the $75,000, which is $50,000.
Penalties for Qualified and Non-Qualified Annuities
Annuities are taxed similar to retirement accounts.
With a retirement account, such as a 401(k) or IRA, if you’re under age 59½ and you take a distribution, you’re penalized 10%.
That’s the exact same thing that happens with either qualified or non-qualified annuities.
The difference is that with a non-qualified annuity, you’re only taxed and have to pay the 10% penalty on the earnings, or gains, because you funded it with after-tax dollars.
If you have a Roth IRA, the IRS treats it as a qualified annuity, even though you funded it with after-tax dollars.
As long as you meet the two requirements: be age 59½ and have held the account for more than 5 years, you will not pay the 10% penalty or taxes on the money withdrawn.
[Related Read: Roth IRAs vs. Traditional IRAs]
Understanding What You’re Purchasing
As mentioned above, how annuities are taxed depends on the type of account you initially set up.
This is why – if you’re not dealing with a financial advisor who is a fiduciary AND someone who truly knows the tax implications of setting up various annuities – you could take a nasty tax hit later on.
A fiduciary is someone who legally must put your interests ahead of their own. They cannot sell you a particular financial product that puts more money in their pocket.
A fiduciary should also talk you through an annuity contract and ensure you fully understand what you are investing in.