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One of the most common questions we get from clients is, “Are annuities taxable?” Annuities are taxed in a relatively complicated manner because how annuity payments are taxed depends on a range of factors, including the type of annuity, the methods used to fund it, and how the funds are withdrawn. This guide will help you dissect different areas of annuity tax and the crucial factors that determine these taxes.
Taxation of Annuities as Ordinary Income
Because they are viewed as an investment, your annuity withdrawal gains or earnings are taxed as ordinary income. This being said, the tax treatment can vary depending on whether the annuity is purchased using qualified or non-qualified funds, and the type of payout option chosen.
Annuities are encouraged to be long-term retirement saving vehicles, and this is why the IRS treats annuities in a certain way for tax purposes. The biggest tax perk is that annuities enable tax deferral — you don’t owe taxes on interest or gains unless you withdraw funds. That’s unlike a certificate of deposit (CD), say, which pays taxable interest in the year earned though you don’t withdraw funds.
So, let’s take a deeper look at whether or not annuities are taxable and in what cases they are.
Key Considerations for Taxation of Annuities
Whether annuities are taxable or not has a lot to do with what the funds used to buy the annuity came from. The first question is, “Where did you get the money to buy the annuity?” The information of the source of the funds will dictate if the annuity is taxable or not.
Though one can never predict future tax laws with certainty, we can see how things are now and make educated guesses about how various alternatives are most likely to be taxed. Here are the most common sources of funds used to purchase annuities and the differing tax treatment based on those sources.
Roth IRA Annuity Taxation
Withdrawals from an annuity purchased using assets from a Roth IRA or Roth 401(k) are generally nontaxable. That is, the amount owed, including principal + interest. The unique features of Roth IRAs are that those withdrawals, including annuity payments, are generally tax free, as long as the Roth IRA has been open for five years and the individual is 59½ years of age or older.
Since Roth accounts use after-tax money, you won’t owe any taxes on the growth inside the annuity. This is one of the most tax-efficient methods of buying an annuity.
Qualified Annuities and Tax Treatment
An annuity purchased with qualified funds—qualified funds being those from a traditional IRA, 401(k), or other plans described as “tax-deferred” accounts—is considered a qualified annuity. All withdrawals that you take after you leave work from qualified annuities are taxed as ordinary income because these distributions have not been taxed before.
Because you weren’t taxed on contributions to these retirement accounts, the IRS taxes the entire distribution as ordinary income when you begin taking withdrawals — including the principal and the interest.
Taxation of Non-Qualified Annuities
Non-qualified annuities are purchased using after-tax money, which means the money was taxed before being invested in the annuity. You only pay taxes on the earnings or gains, not the initial amount you invested (known as your “cost basis”) for these kinds of annuities.
The cost basis is the amount of money you originally invested, and since you already paid taxes on that, you aren’t taxed again when you start taking withdrawals. But any interest or growth on that investment gets taxed as ordinary income when you pull it out. The insurance company keeps track of your cost basis, so you only pay taxes on the earnings portion of your annuity. This works to limit how much cash is taxed for the annuity as it matures.
What Is the Tax Treatment of Continuous Annuities?
With a lifetime annuity, you’re guaranteed payments until you die. The IRS uses life expectancy tables when calculating the taxable amount of your payments to determine how many payments are expected.
Let’s say you buy a lifetime income annuity at age 65 for $200,000. The IRS assumes, based on your life expectancy, that you will receive monthly pay-outs for 20 years. If your annuity pays you $1,167 a month, or $14,000 a year, the IRS assumes you’ll receive $280,000 over 20 years. The taxable amount of each payment is calculated as the expected gain of $80,000 divided by the total number of payments of 240 monthly payments. That leaves a monthly taxable amount of $333.33. In this case, its taxable 28.6%, while 71.4% is not taxable.
How Are Income Payments From Annuities Taxed?
For example, a period-certain annuity guarantees payments for a specific period. Suppose you buy a 10-year period-certain annuity for $200,000, paying you $24,000 per year. So over the 10 years, you’d get $240,000. In this scenario, the taxable part of an annuity would be the interest or gain in the contract. If the total gain were $40,000, you’d owe taxes on that $40,000. To find the taxable amount of each monthly payment, we simply take the total gain and divide it by the number of monthly payments. For instance, $40,000 divided by 120 (the number of monthly payments) is $333.33. This is the amount that each $2,000 monthly payment is taxable.
In this case, 13% of each payment is taxable, while 87% of each payment is tax-free (this is your exclusion ratio).
Conclusion
Overall, the taxability of annuities will depend on what type of funds were used to purchase the annuity and what type of annuity it is. When planning for retirement, it is important to understand the tax implications of annuities. The tax treatment of your annuity depends on whether it is funded with qualified or non-qualified money, whether it is a lifetime or period-certain annuity, and your age when you start withdrawing from it.
