Annuities can be a valuable component of a well-rounded retirement strategy, providing a steady income stream in your post-working years. However, the tax implications of different annuities can significantly affect the net income you receive.
Taxation policies around annuities are complex and may vary based on the type of annuity you buy, how you fund it, and when you decide to withdraw money or start receiving income. Keep reading to see how your annuity may be taxed, and how to minimize your tax burden.
Note: Any reference to the taxation of annuities in this material is based on Annuitiy.com’s understanding of current tax laws. We do not provide tax or legal advice. Please consult a qualified tax professional regarding your personal situation.
Annuities and Tax-Deferred Growth
One of the primary benefits of deferred annuities is their tax-deferred growth. This means the interest or earnings accumulating on your annuity aren’t subject to income tax until you withdraw the funds. This may allow your annuity to grow at a faster rate compared to investments subject to annual taxation, like bank CDs.
Choosing between an immediate vs. deferred annuity can also make a difference. Deferred annuities can remain in force for many years, enabling you to put off taxes until the distribution phase begins. Immediate annuities typically must begin payouts within a year of purchase, giving you quicker access to income but no accumulation period.
Taxation at Withdrawal
Pre-Tax vs Post-Tax Annuity Funding
When you begin withdrawing from your annuity, typically at retirement, the funds are taxed as ordinary income. However, the method used to purchase the annuity—whether with pre-tax or post-tax dollars—significantly influences its tax treatment.
If you purchase your annuity through a qualified plan like a traditional IRA or 401(k), the funds used are pre-tax dollars. This means that when you begin taking withdrawals or receiving payments, the entire amount will be fully taxable. This is known as a qualified annuity.
If you buy an annuity with post-tax dollars or using a Roth IRA, your contributions have already been taxed. This is called a nonqualified annuity. When you start receiving annuity payments from a nonqualified annuity, you’ll owe ordinary income tax only on the interest your annuity was credited over time.
Distribution Method and Taxes
Once the surrender period for an annuity is over, you can access the funds in your account value in multiple ways. Each of these options affects how you’ll pay taxes, and how much you’ll owe at once.
One option is to receive a lump sum distribution of the total account value. In this case, the interest earned on your annuity (or the entire amount if the annuity is qualified) is taxable in the year of withdrawal. This might push you into a higher tax bracket, resulting in a larger tax bill.
You can also choose to annuitize your annuity to begin a stream of periodic payments that can last for a period of years or life depending on your contract. Each payment is considered part earnings (taxable income) and part return of principal (non-taxable if the annuity was purchased with after-tax dollars). This approach, known as the ‘exclusion ratio,’ spreads the tax burden over the life of the annuity payments.
Withdrawals During the Accumulation Period
If you want to make withdrawals but also allow the annuity to continue accruing value, you can opt to make smaller withdrawals over time. Like annuitized income, each withdrawal will be taxed as regular income. The amount of the withdrawal that is taxable depends on whether the annuity is qualified or nonqualified.
Note: All guarantees are subject to the claims-paying ability of the insurer.
Early Withdrawal Penalties
Another critical aspect to consider is the timing of your withdrawals. Deferred annuities typically have an accumulation phase and an annuitization phase. If you take money out during the surrender period of the accumulation phase, you’ll still have to pay income taxes based on the annuity type and interest earned.
However, you may also face contractual surrender penalties from the insurer and additional tax exposure. Generally, withdrawals made prior to age 59½ are subject to a 10% early withdrawal penalty from the IRS on top of regular income tax.
Strategies for Minimizing Your Tax Burden
Given the complex tax implications of annuities, here are some strategies to minimize your tax burden:
- Consider purchasing a deferred annuity, like a multi-year guaranteed annuity (MYGA) or qualified longevity annuity contract (QLAC) for extended tax-deferral benefits. The longer your money grows tax-deferred, the more income you may have when you start receiving payments.
- If available, consider using a Roth IRA to buy your annuity. Since Roth accounts are funded with post-tax dollars, withdrawals in retirement are usually tax-free, including the gains once tax rules are met.
- Use a strategy known as ‘laddering,’ where you purchase multiple annuities over time. This may help diversify your tax burden by allowing you to time withdrawals to coincide with lower-income years, possibly resulting in a lower tax rate.
Final Thoughts
Annuity taxes can be confusing and depend on a variety of factors, including your personal tax situation and the specific terms of your annuity contract. It’s always a good idea to consult a financial advisor or tax professional to determine the best tax strategy for your specific situation.
If you’re ready to buy an annuity but aren’t sure what type to purchase, a licensed annuity agent can help you find an annuity that is most suitable for your circumstance from the right provider for you.
