What You Need to Know About Annuities and Taxes

Annuities are products issued by insurance to provide a guaranteed income when one retires. Annuities are usually paid periodically until certain events occur, e.g., the death of a person. Money invested in the annuity experiences deferred-tax growth until it is withdrawn. An annuity can be jointly owned, unlike the IRA. Annuities don’t have annual contribution limits or income restrictions.

The single premium annuity allows you to fund at once or pay over time. An immediate payment annuity involves fixed payments soon as the investment is made. For a deferred annuity, the principal grows until a specific time until you start making withdrawals, usually at retirement. Earlier withdrawals will come with penalties.

One major tax benefit of annuities is that investments will grow tax-free until funds are withdrawn. This will include capital gains, dividends, and interest that can be reinvested in the annuity. Your investment will grow without being reduced by tax payments. However, complex details explain what funds will be taxed and how these funds will be taxed. Consult your tax professional before purchasing an annuity and before making a withdrawal.

Are annuities taxable?

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Annuities are tax-deferred but not a way to avoid taxes completely. Taxes are not due until you start receiving income payments from your annuity. Withdrawals and lump-sum distributions will be taxed as ordinary income. They are not taxed as capital gains.

How are annuities taxed?

The key determiner here is whether you have a qualified or a non-qualified account. 

A qualified annuity is funded with untaxed money, and payments are taxable as income. The non-qualified annuity is funded with after-tax funds and payments. The exclusion ratio determines taxation.

Qualified annuity taxation

A qualified annuity is the one funded with money that no taxes have been previously paid. The main source of the money is a tax-deferred retirement account, IRAs, and 401(k)s. Payments received from a qualified annuity are fully taxable as income. However, annuities purchased with an IRA or Roth 401(k) will come tax-free if all requirements are met. 

Non-qualified annuity taxation

A non-qualified annuity is the one purchased with after-tax funds. They require tax payments only on the earnings. The exclusion ratio determines the amount of taxes paid. The exclusion ratio determines the percentage of annuity income payments that are taxable and how much is not. It will be used to determine the amount of payment or withdrawal from an annuity from the already taxed principal and the amount considered taxable earnings. The exclusion ratio is used in determining the amount used to purchase the annuity, time length of the annuity and interest earnings, said Mark Luscombe, principal federal tax analyst of Wolters Kluwer Tax & Accounting US.

However, the taxes you pay will be affected if your non-qualified annuity is based on your life expectancy, and you happen to live longer than expected. Let’s say you start receiving payments at 65, and you expect to die before 85. From 65 to 85, everything is partially taxable based on your exclusion ratio. If you live beyond 85, you could be subject to tax. 

Annuity fees

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An annuity is an investment instrument inside an insurance policy; meaning fees can be high. You pay fees for the insurance, management fees for the investment, surrender charges, and fees for riders. IRA carries a small custodial fee that is charged by the financial institution that holds your accounts. IRAs charge their management needs annually, called the expense ratios.

Gifts and assignments of annuity contracts

If your contract owner gives you an annuity as a gift, the owner of the contract might have to pay income tax at the end of the transfer. The contract owner must include surrender value and the owner’s investment in the contract during the time of transfer. This, however, does not apply if the transfer is made between spouses or former spouses as part of a divorce. 

Any agreement to assign or pledge any portion of the annuity contracts cash surrender value will be treated as a withdrawal of such amount from the contract. Tax treatment applies to withdrawals and assignments or pledges of annuity contracts.

Partial annuitizations

There are instances where an owner of a deferred annuity chooses to apply only a portion of the contract’s cash value to produce a series of annuity payments under the contract. That leaves the contracts remaining cash value in the deferral or the accumulation stage.

Before 2011, there was no specific rule in the tax code regarding partial annuitizations. Starting 2011, there started tax codes that provided partial annuitizations of non-qualified annuities. They are treated as other annuitizations so long as the annuity payment periods last more than 10 years or for life for some individuals. Annuitized and non-annuitized portions of the contract will be treated separately. The after-tax investment in the contract is allocated pro-rata in between them to apply rules that govern taxations and distributions. 

The taxable portion of your pensions and annuities

According to IRS, if you contributed after-tax dollars to your annuity or pension, your payments will be partially taxable. You won’t pay taxes on the payment portion that represents a return of the after-tax amount you paid. This amount represents your cost in the investment planned your employer contribution that was taxable as income.

Contributions made with after-tax income where you never took a tax deduction are not taxable to now. You already have paid taxes for that money once. 

FAQ:

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Do you pay tax on an annuity?

Buy an annuity and take up to 25% of your pension pot tax-free as cash. You pay taxes on the income from the annuity, like for a salary. It doesn’t use up any of your allowances. 

How can I avoid paying taxes on annuities?

Take any money remaining in the inherited annuity in a single lump-sum. Also, spread out payments from an inherited payment annuity and pay tax distributions as you go.

Is life insurance annuity taxable?

Beneficiaries of life insurance policies won’t have to pay income taxes on death benefits payouts. Consider a lump sum and ensure the policy is not combined with specific annuity contracts.

Are variable annuities tax-free?

You won’t get taxed until you withdraw your money. If you invested with tax-free dollars, earnings would be taxed as income. Otherwise, the rest will be a tax-free return of principal.

What is a free withdrawal on an annuity?

It is the amount that an annuity contract owner can withdraw every year without incurring early withdrawal fees. The amount varies but majorly 10% per annum until the surrender charge period expires.  

 

For more information on annuity, our financial experts are here to help.

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