Are Annuities Taxable? How Are Annuities Taxed? Learn Here!

Annuities are insurance products that grow tax-deferred, and they are often used for retirement planning. But what exactly does “tax-deferred” mean?

Annuities are tax-deferred, which means that taxes aren't due until you start receiving payments from the contract. However, early withdrawals are taxed as ordinary income. Click To Tweet

If you’re asking yourself this question, you’re in the right place. Today, we will be answering all of the most commonly asked questions regarding tax rules and annuity contracts, including:

  • Are annuities taxable?
  • How are annuities taxed?
  • What’s the difference between qualified vs. nonqualified annuity in terms of income taxation?
  • What are the general tax benefits you can expect from annuities?

We’ve covered all that – and more. So, keep reading!

Are Annuities Taxable?

The most general answer to this question would be:

Annuities are tax-deferred, which means they grow with certain advantages, and you don’t have to pay taxes until you receive income payments.

To get an estimate of how much you would pay in that case, keep reading – we’ve explained it all below.

Also, bear in mind that lump-sum distributions (or any withdrawals) from your annuity are taxable.

Income withdrawn from a qualified annuity is taxable, and you will pay normal income taxes. On the other hand, the interest on non-qualified is subject to income taxes, but they grow tax-deferred. With that in mind, we will explain these two types of annuities below.

Keep in mind that more factors affect whether you will pay taxes, though, including the type of annuity and payouts.

Qualified Annuity vs. Non-Qualified Annuity

One of the major considerations for the tax treatment of your annuity is whether it is qualified or non-qualified. What separates these two types of annuities is how you received the money that you used to purchase them.

Qualified Annuities

Qualified annuities are funded by pre-tax dollars, which means that you didn’t pay taxes on the money you used to buy them.

This type of annuities is usually funded from a retirement account for tax purposes – e.g., Roth IRA or 401(k).

Therefore, you pay tax on the entire distribution of a qualified annuity, just like with any income tax, if you pay it with pre-tax dollars.

Annuities purchased with a 401(k) or Roth IRA can be tax-free under certain conditions, but you would have to speak to a tax professional.

Non-Qualified Annuities

A non-qualified annuity is paid with post-tax dollars and therefore grows with certain tax advantages. That means that you can fund the premium for non-qualified annuities with post-tax dollars, for example – from your taxable bank account or brokerage account.

Only the interest within the annuity is subject to ordinary income tax, but you do not pay on the premium that you deposit.

Therefore, similarly to a retirement plan, non-qualified annuities offer you a tax-free benefit up to IRS (Internal Revenue Service) limits on your contributions.

Annuity Payments: Period Vs. Lifetime Annuity

Annuity taxation will also depend on the type of annuity you have because it directly influences how you will receive annuity payments.

Here, we will discuss the most basic categories – period and lifetime annuities.

If you’re interested in more sub-types of annuities, you can scroll down to the “annuity types” section, where we’ve briefly explained them. Now, back to the topic:

A lifetime annuity will provide guaranteed income in periodic monthly payments, and annuity payouts will usually last for as long as you live. It is the type that most people consider as part of their retirement plan.

On the other hand, a period annuity will provide an annuity payout for a certain amount of years stated in the contract.

In both cases, we are talking about non-qualified annuity payments. Once you got that down, we can move to the next question:

How Much Tax Do You Pay On Annuity Income?

With period annuities – those that last for a specific period of time – it’s easier to get estimates of how much you would pay. You should, most generally, multiply the amount of the annual payments by the number of payments.

To put it in practice:

Say that you have a 5-year contract that pays $10,000 a year. You multiply it by five times and get the expected return of $50,000.

With lifetime annuities, you will first have to estimate your life expectancy. Then, you should multiply the size of the annual payments by the number of years according to the life expectancy after you start receiving payments.

Again, let’s pose this hypothetically:

Say that someone is 65, and according to the life expectancy, they will live to 85 – so, 20 years. They have a lifetime annuity with $10,000 payouts in a year. So, they should multiply that by 20 years, and they will get a return of $200,000.

Now, to see what part of your income stream is tax-free, the basis of your annuity should be divided by the expected return that we’ve just explained. That percentage is the exclusion ratio that won’t be subject to taxes.

How Much Of My Annuity Is Taxable?

After you calculate the exclusion ratio – the percentage between your payment and the expected return – you can see what part of your annuity is tax-free.

Again, let’s see an example:

Let’s say that an individual paid $100,000 in their lifetime annuity, and the expected return is $140,000. When we apply the formula and divide the basis by the expected return, we get the exclusion ratio of 71%.

So, that means that 71% of their monthly payments would be tax-free.

Are Annuities Taxed As Ordinary Income?

Any annuity payment through a qualified annuity – we’ve explained what this means above – is fully taxable and taxed as ordinary income. So, that means that you won’t make use of the favorable capital gains rate like you would in the non-qualified annuities, and you would pay all the income taxes on the whole contribution.

On the other hand, a non-qualified annuity – an annuity purchased with money on which you’ve already paid taxes – is not taxed as ordinary income, and you have certain tax benefits. Namely, non-qualified income payments are made up of two parts. The return on your cost for purchasing this insurance product is free of taxes, great for retirement savings, and the rest is considered as earnings that are taxable.

However, if you withdraw money early from an annuity, you will have to pay the penalty – but more about it below.

Early Annuity Withdrawals Penalty

When you withdraw funds, that will also affect the tax implications.

If you withdraw money before you’re 59½, there will usually be a 10% early withdrawal penalty tax – whether it’s a single sum or monthly payments.

The standard qualified and non-qualified annuity taxation rules are applied for early withdrawals, which means you will pay a 10% penalty on the entire distribution of a qualified annuity.

On the flip side, if you withdraw money from non-qualified annuities, the penalty will only apply to the interest earnings.

There are exceptions to the early-withdrawal penalty – but you should always speak to a tax professional before you decide to withdraw money from your annuity.

Tax Advantages In Retirement Income Planning

The main characteristic of annuities that makes them a good part of the plan for retirement savings and income stream is that they have certain advantages. Namely, they grow tax-free until you withdraw the funds. This part encompasses interest, dividends, and capital gains. You can invest the cash value while it’s still in the annuity.

In other words, your investment will grow without being affected and reduced by taxes.

Inherited Annuities – Do Beneficiaries Pay Taxes?

The taxable portion of inherited annuities depends on the structure of the content. The beneficiary usually has three options:

  • To receive the remaining value of the annuity contract in a single payment
  • To receive payments based on their life expectancy (if a non-qualified stretch provision was included in the annuity contract)
  • Withdraw amounts partially during five years, or the total sum in the fifth year (in case the five-year rule is applied)

A surviving spouse, as a beneficiary, also has the option to change the terms of the contract and become the new annuitant. In that sense, annuities can be used not only as retirement savings but also to ensure that you have a long-term financial security plan.

Annuity Types

The way in which your annuity will be taxed will also depend on its type. We won’t dwell too much on it – but it’s good to get acquainted with the basic types of annuities here:

  • Fixed Annuities – A fixed annuity has a guaranteed rate of interest, and investment gains on this fixed rate are free of taxes as long as the growth stays in your annuity.
  • MYGAs – MYGAs stand for Multi-Year Guaranteed Annuity, and it’s a sub-type of fixed annuities for it also offers a fixed rate, but for a certain period of time (e.g., 2 years, or 5, or 10). The same taxation rules as described above apply.
  • FIA – Fixed Indexed Annuities depend on the market index, but there’s a minimum “floor” that protects you in case of a loss. Over time, it can grow exponentially, just like the other types, as the growth isn’t subject to taxes.
  • SPIA – It stands for Single-Premium Annuity, funded by a single large sum. As with the other annuities, once you receive income payments, you’ll have the non-taxable return and taxable gain.
  • Variable Annuity – Variable annuities don’t have a fixed interest rate, and as such, offer more risk but also higher opportunities for growth. Variable annuity withdrawals, just like with other types of annuities, are subject to a penalty – which means you can’t just withdraw funds if you feel like the interest rate is favorable at a certain point.

Best Annuity Rates

When you’re purchasing an annuity, there are so many factors that have to be taken into account:

First, you need to choose the type that works best for you; then, you need to find the right insurance company that has what you need – not to mention an overwhelming amount of insurance terms.

So, we’ve decided to simplify it for our customers.

We can provide you with an annuity rate calculator that generates free quotes from multiple insurers for you. These are all the most reputable names in the industry, and they offer the highest interest rates and cheap annuity quotes.

The best part is – you can compare the rates for free here, and you’ll receive them instantly because we speak directly to the insurance companies.

There are no obligations, and quotes are informative. If you decide to proceed, we can also assist you throughout the process.

Also, an Insurance Geek agent can help you with any questions you may have regarding your annuities or any insurance-related inquiries. Talk to us today!

Final Words

We’ve provided a comprehensive answer to how is an annuity taxed – along with more info on tax rules. We hope that you found the info you were looking for in our guide. Still, if you have any more questions, we’ve got you covered, as we are experts when it comes to annuities and other insurance-related matters.

Our insurance agents are also financial advisors and can help you find the option that caters to your budget and needs.

Furthermore, we can help you find the right life insurance company that offers annuities, as we’ve partnered with over 30 carriers. If you use our annuity rate calculator, you will get quotes for your premium for free.

See you next time!