annuities

How Annuities Are Taxed

The rules vary based on the type of annuity and how you take the money.

I enjoyed your article Guaranteed Income for Life. Now I'm wondering how annuities are taxed. Can I buy an annuity with funds in my IRA? And what if I use after-tax dollars in a nonretirement account -- is a portion of each payment considered a return of principal?

The tax rules vary based on the type of annuity and how you take the money.

You can buy an annuity with funds in your IRA, and if you use pretax money from an IRA or a 401(k) to purchase the annuity, then all payouts will be fully taxed. If you use after-tax dollars to buy the annuity, however, then a portion of the payouts will be a tax-free return of your principal. Either way, you'll have to pay any taxes that you owe on the annuity at your ordinary income-tax rate, not the preferable capital-gains rate.

There are two types of annuities: immediate and deferred. With an immediate annuity, you hand over the principal to an insurance company and in return receive income for life. If you buy the annuity with after-tax money, then a portion of every payout represents a return of your original investment, and a portion is considered to be taxable earnings.

The money you invested in the immediate annuity is returned in equal tax-free installments over the payment period. If you have a life annuity with payouts that will stop when you die, for example, then that payment period is the IRS's life-expectancy number for someone your age. You'll owe taxes only on any portion of each payout beyond the tax-free return of principal.

Say, for example, you invest $100,000 in an immediate annuity and the annual payouts are $8,000. If the IRS considers your life expectancy to be 20 years, divide $100,000 by 20 to determine how much of each payout will be a tax-free return of investment. In this case, $5,000 of each $8,000 payout would be tax-free and $3,000 would be taxed at ordinary income-tax rates.

[EMBED TYPE=POLL ID=23341]

If you have a deferred annuity, on the other hand, you may not receive any payouts for years. You usually invest money while you're working, and it grows tax-deferred in the account until you need it in retirement. If you have a variable deferred annuity with several mutual funds to choose from, you can shift the money from one fund to another without having to pay taxes -- as long as you don't withdraw the money.

You can also make tax-free exchanges from one deferred annuity to another as long as you don't withdraw the money in between, in a transaction called a "1035 exchange" (you may, however, have to pay a surrender charge to the insurance company if you switch out just a few years after buying the annuity).

You are taxed when you withdraw money from the annuity. If you buy the annuity with pretax money, then the entire balance will be taxable. If you use after-tax funds, however, then you'll be taxed only on the earnings.

If you cash out a deferred annuity in a lump sum, then you'll have to pay income taxes on all of the earnings higher than your original investment. If you take several smaller withdrawals from the account, however, then the IRS considers your first withdrawals to come entirely from interest and earnings. That means you'll be taxed on all of your withdrawals until you take out all of the interest and earnings. Only after that can the principal be withdrawn without taxes.

Say, for example, that you invest $25,000 in a deferred annuity and the investments increase in value by $20,000, making the account worth $45,000. The first $20,000 you withdraw is considered to be taxable earnings, so you'll pay taxes on all of the withdrawals up to that level before you can withdraw the original $25,000 investment without taxes.

Another withdrawal option is to annuitize a deferred annuity, which means you convert the deferred annuity to a lifetime income stream. In that case, you'll receive a portion of every payout as a tax-free return of principal, just as you would with an immediate annuity.

Most Popular

Election 2020: Joe Biden's Tax Plans
taxes

Election 2020: Joe Biden's Tax Plans

With the economy in trouble, tax policy takes on added importance in the 2020 presidential election. So, let's take a look at what Joe Biden has said …
October 15, 2020
Election 2020: States With Tax Questions on the Ballot
Politics

Election 2020: States With Tax Questions on the Ballot

On November 3, voters in 17 states will weigh in on a variety of proposed changes impacting taxes on everything from property to pot.
October 15, 2020
Will Joe Biden Raise YOUR Taxes?
taxes

Will Joe Biden Raise YOUR Taxes?

There's little doubt that, if elected, Joe Biden will try to raise taxes for some people. Will you be one of them?
October 16, 2020

Recommended

When Retirees Question More Retirement Income
annuities

When Retirees Question More Retirement Income

What would you say if I told you that you could safely get significantly more retirement income from your retirement savings? That’s what I call an In…
October 20, 2020
Will Joe Biden Raise YOUR Taxes?
taxes

Will Joe Biden Raise YOUR Taxes?

There's little doubt that, if elected, Joe Biden will try to raise taxes for some people. Will you be one of them?
October 16, 2020
Tax Extension Deadline: File Your 2019 Return by October 15 to Avoid Penalties
tax deadline

Tax Extension Deadline: File Your 2019 Return by October 15 to Avoid Penalties

If you chose to extend your tax return's due date, the tax extension deadline is October 15!
October 15, 2020
How Much Insurance Should You Get? A Lawyer’s Advice
insurance

How Much Insurance Should You Get? A Lawyer’s Advice

The advice to “Only pay for what you need” sounds good. But when it comes to home, auto and business insurance coverage, four guidelines could help de…
October 12, 2020