Finance with Gerald Dewes: How Are Annuities Taxed?

One of the most attractive features of an annuity is its tax-deferred status and investments grow free of tax until withdrawn at age 59½ or later. It includes interest, dividend and capital gains which can be fully reinvested while being in annuity. How Are Annuities Taxed? Read Review.

As simple annuities appear to be on surface, they are a combination of various complexities including which amounts are taxed, when they’re taxed and how they’re taxed, etc. Gerald Dewes

Annuities being tax-deferred do not exclude them to being taxable altogether. They’re taxed as ordinary income and not receive the benefit of being taxed as capital gains. With respect to method of taxation, annuities are of two types: Qualified annuity and Non-qualified annuity.

How Are Annuities Taxed?

Qualified annuities (such as annuities in an employer-sponsored retirement plan or an IRA) are typically purchased with money on which no taxes have previously been paid, so withdrawals are fully taxed as ordinary income.

Some key points to remember are that purchasing an annuity in an IRA or an employer plan provides no additional tax benefits than those available through the original tax-deferred retirement plan whereas Roth IRA or Roth 401(k) are absolutely tax free provided certain criteria is met.

Non-qualified annuities are annuities purchased with after-tax funds and taxable upon withdrawal, but only the earnings are taxed. Non-qualified annuities bought after August 13, 1982, are taxed on LIFO (Last In-First Out) basis.

This means that the accrued interest will be the first money taken out and taxed as ordinary income as you take withdrawals. After the payment of interest, the initial investment amount will then be distributed without any further taxes.

Taxes on non-qualified annuities are determined using the “exclusion ratio”. It is used to determine what percentage of annuity payments is taxable and what is not.

Exclusion ratio calculation takes into account principal used to purchase the annuity, the period of time annuity has existed, interest earnings and life expectancy of the annuitant.

The important point to note regarding life expectancy is that if the annuitant lives longer than its actuarial life expected, annuity payments received after that age are absolutely taxable.

The way you withdraw your annuity and the time period after which you withdraw also affects your taxable income for that year. Most annuities may have surrender charges which are assessed in the early years of the annuity contract in case if the contract owner surrenders the annuity. If you withdraw funds before age 59½, you may be subject to a 10% federal income tax penalty on the taxable portion of the withdrawal.

Also, withdrawing lump sum amount rather than following an income stream also will trigger tax on your earnings and income tax will be paid on the entire taxable portion of funds.

 The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the ­purpose of ­avoiding any ­federal tax penalties. You are encouraged to seek advice from an independent tax or legal professional. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the ­purchase or sale of any security.

IMPORTANT DISCLOSURES

Gerald R. Dewes does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.