How to Calculate the Tax Bill on Withdrawals from Variable Annuities

Some or all of your withdrawals could be taxed, depending on how you made your initial investment and how you’re pulling money out.

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Question: I invested $150,000 in a variable annuity about 15 years ago and haven’t taken any withdrawals yet. Now that I’m in my late sixties, I’d like to start tapping the account, which is now worth about $210,000. How will the withdrawals be taxed?

Answer:

Variable annuities aren’t taxed until you withdraw the money. The amount that will be taxed depends on the way you made your initial investment and the way you take withdrawals.

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If all of the money you invested was pretax or tax-deductible (for example, if you bought the annuity within a 401(k) or traditional IRA), all of your withdrawals will be subject to income taxes. But if you invested using after-tax dollars, the earnings will be taxed as income, and the rest will be a tax-free return of principal.

However, the way your earnings and principal are calculated depends on how you take the withdrawals. Say you cash in the entire annuity for a lump sum. You’ll have to pay income taxes on all of the earnings in one year – in your case, $60,000 of the $210,000. But if you withdraw some of the money and keep the rest growing in the account, your first withdrawals will be considered taxable earnings. Once you’ve pulled out all of the earnings, any further withdrawals will be considered a tax-free return of principal. Your insurer will calculate the portion of principal and earnings for each withdrawal.

Kimberly Lankford
Contributing Editor, Kiplinger's Personal Finance

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.