Are Annuities Taxable?
Written by
Jacob Wade
Edited by
Melanie Grafil
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Annuities offer some tax benefits–namely that growth within your annuity is tax deferred until you begin receiving payouts in retirement. And annuities can also be placed in retirement accounts to save on taxes while funding the policy.
But taxes on annuities are slightly complicated–and you might be hit with penalties if you don’t manage your annuity correctly. We’ll review how annuities are taxed, the different types of annuity taxation, and how to report annuities on your tax return.
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How Are Annuities Taxed?
Annuities are a unique financial instrument in that taxes within an annuity can be deferred until you begin receiving payouts from the policy. While they are not quite the same as an Individual Retirement Account or 401(k)–the tax treatment is similar.
When you fund an annuity, the money within the policy typically earns interest. Some annuities also allow your funds to grow by investing in mutual funds or providing returns that mirror a stock market index, such as the S&P 500. Any earnings within your annuity are not taxed right away–taxes are deferred until you start receiving your annuity payouts.
There are two main types of annuities that offer different tax treatment:
Qualified Annuity Taxation
A qualified annuity is any annuity that is held within a qualified retirement account. A majority of these annuities are held in workplace retirement accounts, and premiums paid into the policy are deducted from your taxable income.
When you begin withdrawals from a qualified annuity, the payments are counted as ordinary income–similar to a traditional IRA. This means you’ll pay taxes at your current income tax rates–but don’t pay taxes on any gains within the account.
Non-Qualified Annuity Taxation
A non-qualified annuity is any annuity that is funded with “after-tax” dollars. These annuities are not usually held within a retirement account and are stand-alone policies. Non-qualified annuities only require paying taxes on any gains within the account.
The taxation of a non-qualified annuity is akin to a regular brokerage account. Once you begin with withdrawing funds from the annuity, you’ll pay taxes on any income or gains from the account at your capital gains tax rate.
What Is the Exclusion Ratio?
For non-qualified annuities–to determine what portion of your payment is considered taxable income–the annuity uses an exclusion ratio. This ratio is based on the amount of principal payments (money you paid into the policy) and total earnings–and considers your life expectancy.
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Example
If you bought a $200,000 annuity with a guaranteed payment of $1,000 per month for the next 20 years, you would divide the annuity amount by your monthly payout and then multiply by your life expectancy (in months). So you would divide $200,000 by $1,000 then divide that by 240 months. This gives you an exclusion ratio of 83.33%—meaning 83.33% of your payments are excluded from your taxable income for a duration of 240 months.
If you outlive the “life expectancy” of the annuity, then all future payments thereafter are considered 100% taxable.
Are Annuity Withdrawals Taxable?
While regular annuity payments are typically taxable–withdrawing funds from your annuity may trigger taxes as well. Since some annuities offer a lump-sum payment vs. monthly payments–the lump-sum is treated as taxable income.
But similar to a monthly payment plan, lump-sum withdrawals from your annuity are taxed based on whether it’s a qualified or non-qualified annuity. Withdrawals from a qualified annuity are all treated as taxable income, while withdrawals from a non-qualified annuity are taxed only on the earnings portion.
Note: If you withdraw funds from your annuity before age 59 ½, you may have to pay an additional 10% penalty on the taxable portion of your annuity.
Last-In-First-Out
When withdrawing funds, or outside of regular annuity payments, from a non-qualified annuity–the IRS uses the “Last-in-first-out” rule for determining the taxable portion of your withdrawal. Since you typically fund the annuity up-front and earnings happen over time, you may end up paying taxes on all of your withdrawal until you’ve withdrawn more than the total earnings amount. For example, if you have a $50,000 annuity that’s now worth $70,000–the first $20,000 you withdraw from the annuity is fully taxable.
How Are Inherited Annuities Taxed?
If you inherit an annuity, payouts from the annuity are taxed the same as if you bought the policy. This means if you inherit the IRA or 401(k) account that an annuity is held within, it is considered a qualified annuity–and payouts are taxed as ordinary income. Conversely, if you inherit a non-qualified annuity, you’re subject to the same exclusion ratio and partly taxable (or fully-taxable) payouts from the annuity.
There are exceptions to many rules, though, so it’s a good idea to meet with a licensed tax professional that specializes in inherited financial assets to help you navigate the tax treatment of an inherited annuity.
How To Report Annuity Income on Your Tax Return
Once you start receiving payouts from your annuity, you’ll need to report these payouts on your annual tax return. If you receive a payout from your annuity over $10, your provider should give you a 100-R form that details your annuity payments–as well as any amounts excluded from your taxable income for non-qualified annuities.
You’ll report your 1099-R income on your tax return, but determining the taxability of your annuity and how to file it properly may require working with a tax professional. You can use IRS publication 575 for the details on how annuities are taxed.
FAQ
- How are annuities given favorable tax treatment?
- Most annuities defer taxes until retirement, allowing your annuity to grow in value without paying annual taxes on any interest or dividends earned within the policy. Non-qualified annuities also pay back your principal investment as part of your monthly payments--allowing you to exclude a portion of your payment from your taxable income.
- How can I avoid paying taxes on annuities?
- If you want to avoid paying taxes on an annuity, you need to hold it in a Roth designated account. Roth accounts are funded with after-tax dollars, but unlike non-qualified annuities, distributions from a Roth account annuity are tax-free. But the Roth account must have been open for at least five years to qualify.[
- Is annuity income taxable?
- For most qualified annuities, the payments are generally taxed as ordinary income. But payments from non-qualified annuities include a repayment of your principal investments--and those principal amounts are excluded from your taxable income. And any annuity payouts from a designated Roth account are tax-free in retirement (after age 59 ½).
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