Annuity income and taxes: Consider qualifications, deferrals, distributions, and more

Open full sized image

This looks complicated. And in many cases, it is.

© Sneksy—E+/Getty Images

If you’re an annuity investor—or you’re considering an annuity investment—you probably know the basic pros and cons. Annuities offer guaranteed income, customized plans, and tax-deferred growth, but with complex structures and layers of fees.

Your annuity will grow tax deferred—that means you don’t pay any taxes until you take money out. But once you begin to take money out of your annuity, do you know how you’ll be taxed?

Whether you’re an annuity owner planning your retirement budget or a younger investor considering annuities as part of a future retirement stream, educate yourself on the tax implications.

Qualified annuities are those that are held inside of a retirement plan such as an individual retirement account (IRA), a 401(k), 403(b), 457(b), or other qualified plan. Taxes on qualified annuities are governed by the type of retirement plan holding the annuity.

Nonqualified annuities are held outside of a retirement plan. Premium payments into the annuity contract are made with after-tax dollars. Money inside the annuity will grow on a tax-deferred basis, but the earnings will be taxed when they’re withdrawn or distributed via annuitization.

If you need to take money out of your nonqualified annuity before you’ve annuitized it, this is called a withdrawal. Withdrawals from a nonqualified annuity are subject to taxes based on a last-in first-out (LIFO) methodology. This means that withdrawals are assumed to come first from any gains (e.g., interest and/or capital appreciation). A partial withdrawal that consists only of money from the gains portion will be fully taxable.

Once the gains are used up, any remaining withdrawals are assumed to be a return of the premiums paid into the contract; there are no taxes on these distributions. Remember that this is a nonqualified plan, so those premiums (which represent your principal) were made with money you already paid taxes on.

According to the IRS, if you withdraw money from your qualified annuity before the annuity starting date, part of your withdrawal may be tax free based on a ratio of what you paid in and the total account balance.

If you take out your entire annuity balance and fully discharge the contract, the amount you receive over the amount you originally paid will be subject to tax (see more below).

Watch out if you decide to take out your annuity money before you’re 59½. Any portion of your annuity withdrawal that’s taxable will be subject to taxes plus a 10% penalty; nontaxable portions do not incur a penalty.

Nonqualified early withdrawals incur the penalty unless the person is terminally ill, disabled or if certain disaster relief exceptions apply.

Qualified annuity early withdrawals incur the penalty unless the exceptions for birth/adoption or medical expenses apply, or if they are exempt under the rule of 55. Note that annuities held in a Roth account also incur a penalty if the account has not been open for five years when a withdrawal is made (the “five year rule”.)

For nonqualified annuities, once an annuity is converted into a stream of periodic monthly payments (“annuitized,” in industry lingo), these receipts will be taxed based on what’s called the exclusion ratio—the ratio of taxable gains and nontaxable premium payments that are included in each payment. Once the amount that is considered to be principal runs out, any additional annuity payments will be fully taxable.

In the case of a qualified annuity, annuity receipts after annuitization will be taxed in the same fashion as any other withdrawal from that particular type of retirement plan. In the case of a traditional IRA or 401(k) where all contributions were made on a pretax basis, all monthly annuity payments will be fully taxable. In the case of a Roth account, the annuity payments will be tax free as long as the Roth account meets the requirements for qualified payments.

If you receive a payment that is not part of your periodic monthly annuity payments, such as a cash payment of a dividend, generally all of that payment will be taxable.

If your qualified annuity is held in a traditional retirement account like an IRA or 401(k), you must take required minimum distributions (RMDs) from these annuities just as you would from any other asset.

RMDs, which are taxed as ordinary income, are based on your age and the balance in the applicable account at the end of the prior year. As of 2024, RMDs must begin the year you turn 73. The IRS has a worksheet that will help you understand RMDs.

Did you inherit a qualified annuity? It will be treated as any other inherited retirement account. A spouse can treat the retirement account as their own and potentially defer distributions and taxes. In the case of other beneficiaries, the annuity will be taxed when distributions are taken, either as a lump sum or periodically.

Inherited nonqualified annuities are taxed based on the annuity gains. Taxation will vary depending on whether you choose a lump sum or periodic distributions.

Annuities can be a key part of your retirement income planning. However, it’s easy to see how complicated they can be from a tax perspective, particularly if you wish to withdraw funds prior to annuitization (and for a qualified plan if you’re under age 59 ½). If you plan to go that route, this may be one instance in which you need some guidance from a tax pro.

After all, the goal with an annuity is to set up a steady and reliable retirement budget that you can count on, and taxes can significantly alter your net monthly income from the annuity.

Before buying an annuity—particularly if you have the choice between buying it inside or outside of a qualified plan such as a 401(k) or IRA—look at your overall tax situation and consider carefully.