Annuities offer powerful tax benefits to those planning for, or entering retirement. Unlike money market accounts, savings accounts, certificate of deposit (CDs), and most bonds, annuities carry the potential to create tax-deferred accumulation. For example, interest earned in a deferred annuity is not taxed until the owner takes withdrawals from the annuity. This accelerates savings growth because the interest compounds without being taxed. However, understanding the full scope of annuity taxation is critical to choosing the annuity product that makes the most sense for you.
In this article, you’ll learn the most important tax implications of different types of annuities. We discuss how qualified and nonqualified annuities differ in their tax structures and various tax rules involved in annuities. Learning these key points will ensure you feel comfortable with your tax-deferred retirement savings.
With an extensive selection of fixed-rate (MYGA), fixed-index, immediate income and deferred income annuities, our friendly, experienced team of annuity agents can guide you through the selection process. Your golden years are meant for enjoyment, not worrying about finances. We ensures you find the right annuity product for your financial retirement goals.
Qualified Annuity Taxation
If you purchase an annuity with money that has not been taxed, it is considered a qualified annuity. These categories of annuities are typically funded with money from 401(k)s or other tax deferred retirement accounts, such as traditional IRAs.
Once you begin taking withdrawals or receiving payments from a non-ROTH qualified annuity, the money received becomes fully taxable as income. The reason for this is because the money you used to fund the annuity has never been taxed. For example, if you buy a $100,000 annuity and receive $6,000 back in an annual payout, you are required to report the entire $6,000 as taxable income.
Non-Qualified Annuity Taxation
If you purchase your annuity with after-tax funds, it is considered a non-qualified annuity. After-tax money means the IRS has already taxed the money used to purchase the annuity. In a non-qualified annuity, only the earnings are taxed.
Annuity withdrawals made from a non-qualified deferred annuity are taxed on a Last In, First Out (LIFO) basis, meaning that accumulated interest earnings are considered to be withdrawn first, before you get any of your tax-free principal back.
Non-qualified income annuities use what is known as an exclusion ratio to determine the amount of income you need to claim. The exclusion ratio determines the percentage of taxable income vs. the percentage of non-taxable return of principal that is included in each income payment. The exclusion ratio takes into account how long you’ve held the annuity before starting income, how much interest you’ve earned and how long the payments will last.
Further Information On How the Exclusion Ratio Works
For further reference on the exclusion ratio, let’s assume you purchase a nonqualified, immediate annuity at age 65. The insurance company determines you have a 20-year life expectancy and agrees to pay a set amount per month for the rest of your life. Your initial investment is expected to earn a return over the next twenty years and the insurance company spreads your principal investment over that time period.
Your annuity pays you $500 per month but your principal investment only accounts for $400 of the $500 monthly payment. The remaining $100 of your monthly payment is considered interest earnings and is the only taxable income in this instance, since $400 is considered a return of your original principal and it has already been taxed. In this case, your exclusion ratio would be 80%, since 80% of your monthly payment has already been taxed.
Further Tax Information On Qualified and Nonqualified Annuities
As previously discussed, qualified annuities are purchased with pre-tax funds, such as IRAs, 401(k)s, and 403(b) plans. Immediate-qualified annuities typically have the highest tax consequences because the return of the money used to buy the annuity and all of the earnings are taxable. Since you start receiving these payments immediately, you start paying taxes immediately.
One of the easiest ways to reduce taxes with annuities is by shifting money from fully taxable investments, such as bank CDs, money market accounts and bonds, into a nonqualified tax-deferred annuity. Shifting your money into a nonqualified deferred annuity helps you avoid taxation on your interest earnings, giving you the flexibility to decide when is the most strategic time to withdraw those earnings.
Annuity Withdrawal Taxation
The biggest tax considerations for withdrawals should be how and when you make your withdrawals. The 59 ½ rule is a critical tax law to consider. It stipulates that if you withdraw money from an annuity before you turn 59 ½, you will incur a ten percent penalty on the taxable portion of the withdrawal.
After age 59 ½, withdrawing your money as a lump sum rather than an income stream triggers income tax on your accumulated earnings. If you decide to do this, you will have to pay income taxes on the entire taxable portion of your funds.
The tax status of the contract, be it qualified or nonqualified, determines how much of your withdrawal will be taxed. In non-ROTH qualified annuities, since the entire annuity is taxable, all of your withdrawal is taxable. In nonqualified annuities, you only pay taxes on the earnings portion of the withdrawal.
Another tax related benefit of annuities is that you are in control as to when you take withdrawals and recognize taxable interest earnings. However, qualified annuities held as non-ROTH retirement accounts are subject to required minimum distribution (RMD) rules. These rules stipulate that you must start taking withdrawals annually after age 73.
Conversely, nonqualified annuities are not subject to RMD rules, so you can accumulate interest without paying tax for as long as you like. This gives you the ability to benefit from additional years of tax deferred growth because you don’t need to make annual withdrawals, at any age.
Another taxing component you should understand is that the earnings you withdraw from all deferred annuities is taxed as ordinary income rather than long-term capital gains, regardless of the type of annuity.
Some Additional Considerations About the 59 ½ Rule
The 59 ½ rule stipulates that you will owe a 10 percent tax penalty on the interest earnings if you withdraw money from your annuity before reaching the age of 59 ½. This penalty is in addition to the ordinary income tax due on the withdrawn earnings.
However, there are some extenuating circumstances to this rule, such as having a permanent disability or terminal illness at the time of your withdrawal. In this case, the IRS will waive the 10 percent tax penalty.
In addition to tax penalties, withdrawals can also be subject to early surrender charges from the annuity issuer. Surrender charges can occur if the withdrawn amount exceeds the penalty-free amount during the surrender charge period. These charges vary based on the annuity product you choose. You should take both your potential tax implications and surrender charges into account when deciding on the annuity that best fits your needs.
Annuity Payout Taxation
Annuity payouts have a slightly different tax structure than direct withdrawals. In a nonqualified annuity that has been annuitized (annuitization), each monthly payment contains a tax-free portion that is considered a return of your original premium deposit and a taxable portion that is your interest earnings.
Nonqualified annuities in the payout phase are structured so they evenly portion the original principal amount over the course of the expected annuity payout term. The earnings portion in your payments that has not been taxed is the only portion subject to income taxes. With qualified annuities, since none of your principal investment used to purchase the annuity has been taxed yet, all of your payout is taxable.
When making withdrawals from a non-annuitized deferred annuity, it should also be noted that IRS rules state you must withdraw all of the taxable interest earnings before withdrawing your tax-free principal. This means you have to pay all of your taxes upfront if you want to start making withdrawals. One tactical move you can make to avoid this tax drawback is to annuitize or exchange an existing fixed-rate, fixed-indexed, or variable deferred annuity into an income annuity.
Inherited Annuity Taxation
If you are inheriting a nonqualified deferred annuity as a beneficiary, there are a few things to consider with regard to taxation. The first determining factor of annuity taxation is whether you’re the spouse of the deceased annuity owner. If you are, you can usually assume ownership, keeping the existing annuity in tact with the same terms. The tax structure won’t change, and you won’t incur any tax penalties.
If you’re not the spouse, there are typically four options to choose from for your payout:
1. Lump sum payout option: you can opt to take the remaining balance from an inherited annuity in a lump sum. In this case, you would have to report the entirety of the taxable portion of the annuity on your tax return.
2. Five-year rule: the five-year rule lets beneficiaries spread out the payments over five-years, which carries some tax deferral benefits.
3. Nonqualified stretch: in a nonqualified stretch option, the beneficiary can stretch the annuity withdrawals over the rest of their life. Their life expectancy would determine the withdrawal amounts and schedule. Not all insurance companies offer this option.
4. Period Certain or Life Annuitized Payout: the contract is annuitized and you receive payments for either a set period of time of for the remainder of your life.
The options that spread out your tax liability the most are the nonqualified stretch or lifetime annuitization. However, in this scenario, you will wait longer to receive the remaining money in the annuity. The lump sum payment method would give you access to the money faster. However, you would take a harder tax hit in the short-term.
Some Other Things Beneficiaries Should Consider
- Children of the annuitant who are beneficiaries are also only required to claim the untaxed portion of the annuity on their tax return.
- If you name a charity as the beneficiary, you can fully or partially offset tax liability.
401(k)s, IRAs, 403(b)s, and pension lump sum payouts can be rolled over into any type of qualified annuity without incurring taxes.
The same deductibility limits apply to qualified annuities for contributions as IRA, 401(k), 403(b) or other qualified plans. You can visit the IRS website for the deductibility limits for IRAs. Premium payments made to nonqualified annuities are not tax deductible.
Exchanges in annuities are relatively simple. You can exchange nonqualified annuities tax-free for a different nonqualified annuity. This is what is referred to as a 1035 exchange. You can also exchange any annuity that has an unappealing product design for one that has more attractive features or one that pays a higher interest rate.
QLACs Reducing and Deferring RMDs
Qualified longevity annuity contracts (QLACs) are qualified annuities that meet IRS requirements and let you exclude up to $200,000 of your IRA balance from RMDs, with payments delayed to as late as age 85. Excluding up to $200,000 of your IRA from RMD requirements until as late as age 85 reduces your taxes until payments begin and allows your money to continue to grow and compound. While your QLAC income is 100% taxable, it’s money you would eventually have to withdraw from your IRA anyway, so it doesn’t worsen your tax situation. In 2023, the maximum amount you can allocate to a QLAC is $200,000.
We Are Is Here to Help
Understanding annuity taxation and the tax deferral benefits that each prospective annuity provides is important. This should help determine whether you opt for a qualified or nonqualified annuity, or an immediate or deferred annuity. Having an annuity agent on your side whose concern is to offer you the most beneficial annuity for your individual needs can help you make informed decisions that are in your best interest.
We believe you should view your annuities as an integral component of your retirement portfolio. You shouldn’t have to stress about tax implications affecting your finances and whether you can achieve tax deferred growth in retirement. You should be able to rest easy knowing you have the most effective annuity for your financial needs and desires.