What You Need to Know About How Annuities are Taxed
You may have heard the term annuity before, but you’re not quite sure what it means or how they work. You’ve heard that they can reduce your taxable income and allow you to grow your investments over time, but you’re not sure how they are taxed or if they are right for you. Here is everything you need to know about how annuities are taxed and whether or not an annuity may be right for you.
Annuity payments are used to secure retirement income and provide an income you can never outlive.
Are Annuities Taxable?
Annuities grow tax deferred. This means that any gains you make on your annuity are not taxed until you begin making withdrawals from your account. When you do begin taking withdrawals, they will be considered ordinary income tax.
The amount of income that is taxable depends on how much money you have in your annuity and how much retirement income you withdraw. The more growth you have, and the more money that is in it, generally means a higher percentage of your withdrawal will be taxable income when you take it out of your annuity account especially if they are pre tax dollars you are withdrawing.
How Are Annuities Taxed?
In general, any contributions that you make to an annuity, such as cash or stocks, is tax-deferred. This means that you won’t pay taxes on those funds until they come out of your annuity. Additionally, any investment earnings inside your annuity aren’t taxed either. When you start taking withdrawals from your annuity plan after retirement age and once your contributions have been withdrawn in full, only then will you be subject to taxation from both state and federal governments.
Deductible, or Nondeductible Premiums?
There is one difference between an annuity that allows for a tax deduction and one that does not: For example, if you contribute $10,000 to a nondeductible annuity, you will reduce your taxable income by $10,000.
Qualified vs Non-Qualified Annuity Taxation
Qualified Annuity Payments
Qualified annuity plans allow taxpayers to lower their taxable income by contributing pre-tax funds to an annuity premium. Qualified annuities permit individuals to defer taxation on an investment earnings stream as long as withdrawals are made according to IRS guidelines.
Non-Qualified Annuity Payments
If the contract was purchased with after-tax funds — meaning money that has been reported to the IRS as income and taxed accordingly — then the annuity is non-qualified. Non-qualified annuities require tax payments on only the gains.
When the annuity was purchased with after-tax funds (e.g. earnings on which the taxpayer was required to pay income tax), then the annuity is classified as non-qualified. This type of annuity can defer taxation on any earnings to a later date.
The taxes on non-qualified annuities is determined by the exclusion ratio. The exclusion ratio is used to calculate what percentage of annuity income payments are taxable income and how much is not.
The objective is to determine the portion of the withdrawal or payment from an annuity that is considered as tax-deferred or nontaxable funds, and how much is to be regarded as taxable earnings. A tax professional can help determine this.
In other words, the exclusion ratio consists of the premium payments used to purchase the annuity, the time the annuity has existed, and the earnings.
Should an annuitant live longer than their life expectancy, annuity payments they receive will be fully taxable after they pass the expected life expectancy.
Annuity Withdrawal Taxation
There is a 10% federal income tax withholding on annuity withdrawals paid before age 59.5, unless you qualify for an exception due to your status as a government employee or church employee.
Withdrawals before age 59.5 may also be subject to additional state and federal income taxes and an additional early withdrawal penalty (typically 10%) of up to $10,000 (or $20,000 if married) under some circumstances.
When you take the withdrawal from the plan, if you withdraw as a lump sum rather than take the withdrawals as an income stream, the IRS will tax your income, as your account has grown in value, this tax bill is only payable when you decide to start withdrawing your money.
You will always pay taxes on withdrawals regardless of the type of annuity, qualified or non-qualified. The tax status of the contract dictates how much you will be taxed, but if it’s a qualified annuity, you will pay taxes on the full withdrawal amount. If you have unqualified earnings, you will pay taxes on gains only.
Taxes on non-qualified annuities and withdrawals use last-in-first-out (LIFO) tax laws.
Once the amount withdrawn exceeds the value the annuity has gained, subsequent withdrawal amounts are considered a tax-free return of your principal and you won’t owe taxes on that amount. If you withdraw $10,000 from an annuity with $5,000 in gains and $5,000 in contributions or earnings over time, only $5,000 will be taxed. The remaining $5,000 is considered a return of your original investment and is not taxed.
You can withdraw funds from an annuity without paying penalties or taxes as long as it’s due to unforeseen circumstances such as losing your job or being disabled.
Annuity Payout Taxation
Regardless of how you take the money out, the contract tax status–either qualified or non-qualified–determines how much will be taxed. If it’s a qualified annuity, the full withdrawal will be taxed. You will only pay normal income taxes on the gains that are non-qualified.
Inherited Annuity Taxation
An inherited annuity has a different tax treatment than a traditional annuity purchased during your lifetime. With an inherited annuity, you may be able to stretch out payments over a period of time or receive them all at once. Any growth in an inherited single premium immediate annuity (SPIA) will be taxed as ordinary income when withdrawn. On the other hand, if there is growth in an inherited fixed-rate immediate annuity, it will not be taxed until withdrawn as part of your taxable income.
The annuity owner is responsible for filing an IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, if payments from a single premium immediate annuity exceed $14,000 in a calendar year. A gift tax return may also be required in some circumstances when there is more than one beneficiary listed on an SPIA. The IRS also considers installment payments from an inherited annuity that continues beyond five years as additional taxable income.
Does a Beneficiary Pay Taxes on an Annuity?
Upon inheritance, an annuity payment has to be included in the beneficiary’s tax filing, which will depend on the recipient’s relationship with the annuity owner and the annuity payout structure.
An estate tax may be required if an annuity is valued at over $11.2 million, which will depend on when and where it was purchased and how much of a payout will be received annually by a beneficiary. The IRS also requires payouts of a non-qualified annuity to begin within five years after death or taxation will be required.
How Much Should I Withhold in Taxes Form My Annuity Payments
With an annuity, you can choose between a fixed and variable rate of return. If you opt for a fixed income stream, your monthly payout will never change regardless of what happens in stock markets. On the other hand, variable-rate payments rise and fall with financial markets—and can increase dramatically or decline sharply depending on market conditions.
Taxes on your annuity distributions or streams of income will depend on whether the annuity was purchased with pre-tax or post-tax money. Your tax withholding approach should be determined based on your annual income and income tax bracket.
An Annuity can provide guaranteed payments for life. Annuities offer many tax benefits on interest earnings and retirement savings. An Annuity growth element is tax free for an annuity owner. An annuity contract is a personal finance tool that can be a much better option than putting your money in a savings account.
There are many annuity types and if you would like to see how an income annuity can benefit you speak with one of our financial advisors today.