Annuities are designed to build wealth and income for your retirement through tax deferral. Interest earned in a deferred annuity (the most popular type) is not taxed until withdrawn. Deferring taxes accelerates savings growth because interest compounds faster without withdrawals needed to pay taxes.
Compounding occurs when interest is paid on previously earned interest. Most investments that earn interest, such as money market accounts, savings accounts, certificates of deposit (CDs) and most bonds, create taxable income. Since you’re paying federal (and often state) income tax on it each year, you’ll have less after-tax interest to compound, and your savings won’t grow as fast.
With a tax-deferred investment, all of your interest is compounded until withdrawn.
From just $107.88 $24.99 for Kiplinger Personal Finance
Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
How annuity withdrawals are taxed
Annuities have some unique tax advantages. In some cases, they can even be used to pay for long-term care without the usual taxes on distributions! But there are some potential tax pitfalls.
Annuities can be purchased with pretax funds or after-tax funds. Pretax accounts, such as IRAs and 401(k) and 403(b) plans, are known as qualified retirement plans. If you use an annuity to fund one of these types of accounts, it’s thus called a “qualified” annuity.
In contrast, “nonqualified” annuities are purchased with ordinary after-tax money. By shifting some of your money into a nonqualified deferred annuity, you can cut your taxes.
Interest earned in both qualified and nonqualified annuities is not reportable on your tax return until you withdraw it. However, qualified annuities held in retirement accounts are subject to required minimum distribution (RMD) rules. You must take withdrawals each year after you reach age 72, or 73 if you reached age 72 in 2023 or later.
Nonqualified annuities are not subject to RMD rules, so interest can continue to compound without tax until you withdraw some or all of it. This gives you great flexibility. Let’s say you do not need more income when you’re 72 or 73. With a nonqualified annuity, you can wait until you do need the income and benefit from more years of tax-deferred growth.
Income withdrawn from all types of deferred annuities is taxed as “ordinary income,” not long-term capital gain income. This tax treatment applies to fixed-rate, fixed-indexed, variable and income annuities.
Here are some key tax wrinkles regarding annuities:
Income annuity payments are only partially taxable
Your original investment — the purchase premium(s) you paid — in a nonqualified annuity is not taxed when withdrawn. Only the interest portion of the payment is taxable.
With a deferred annuity, IRS rules state that you must withdraw all of the taxable interest first before withdrawing any tax-free principal. You can avoid this significant drawback by converting an existing fixed-rate, fixed-indexed or variable deferred annuity into an income annuity. Or you can buy an income annuity in the first place.
An income annuity provides a stream of guaranteed payments, starting either right away with an immediate annuity or in the future with a deferred income annuity. As mentioned above, each payment includes both taxable interest and tax-free return of your premium.
The exclusion ratio depends on how long you’ve held the annuity, how much interest you’ve earned and how long the payments will last, but, for example, 75% of each payment might be tax-free return of principal and 25% taxable.
The age 59½ rule
If you withdraw money from your annuity before age 59½, you’ll typically owe Uncle Sam a 10% penalty on the interest earnings you’ve withdrawn as well as ordinary income tax on the amount. If you are permanently disabled at the time of the withdrawal, the IRS will waive this penalty.
A unique tax perk for long-term care
Annuity interest that is used to pay long-term care insurance premiums or qualified long-term care expenses can usually be withdrawn tax-free. This can be a big advantage.
Taxes at death
If you’re married, your spouse can assume the ownership of your qualified or nonqualified annuity at your death without any taxes.
Children who are beneficiaries are required to claim only the untaxed portion of the annuity on their tax return. Under certain circumstances, the annuity can be distributed and taxed over a number of years. If you name a charity as your beneficiary, you can partially or fully offset income tax liability.
Rollovers
You can roll over your IRA, 401(k) or 403(b) or pension plan lump-sum payout into any type of qualified annuity without taxes.
Deductibility
Contributions made to a qualified annuity are deductible within IRS limits for retirement plans. In other words, the same deductibility limits apply to qualified annuities as they would for any other IRA, 401(k) or 403(b) or other qualified plan. (See the IRS website for deductibility limits for IRAs.) Premium payments to nonqualified annuities are not.
Exchanges
Nonqualified annuities may be exchanged tax-free for another nonqualified annuity — a so-called 1035 exchange. You can trade an annuity that may not have the features you like for another annuity that has better features or may pay a higher rate.
Qualified immediate annuities
Because the funds in a pretax qualified annuity have never been taxed, the total amount of the payments received each year is taxable. These amounts count toward your RMDs.
A QLAC lets you reduce and defer RMDs
A qualified longevity annuity contract, or QLAC, is a qualified annuity that meets IRS requirements. QLAC income is 100% taxable, but it’s money you’d eventually have to withdraw from your IRA anyway. Payments can start at any age as long as they begin by age 85.
Over your lifetime, you can reallocate up to $200,000 from your IRAs to a QLAC.
A free quote comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling 800-239-0356.
Related Content
- The Best Way to Defer RMDs (and Their Tax Bills): QLACs
- How Annuities Can Help You Retire Early and Delay Social Security
- Fixed Indexed Annuities Can Be a Potent Diversifying Tool
- Are Bonus Annuities a Good Deal?
- Too Heavy in Stocks? Annuities Could Be a Rebalancing Option
-
3 Ways to Stretch the 2026 Social Security COLA For Your BudgetThree steps retirees can take to stretch the Social Security COLA to fit their budgets.
-
How to Keep Your Charitable Giving Momentum Going All YearInstead of treating charity like a year-end rush for tax breaks, consider using smart tools like DAFs and recurring grants for maximum impact all the year.
-
Uber Takes Aim at the Bottom Lines of Billboard LawyersUber has filed lawsuits and proposed a ballot initiative, in California, to curb settlements it claims are falsely inflated by some personal injury lawyers.
-
Giving Tuesday Is Just the Start: An Expert Guide to Keeping Your Charitable Giving Momentum Going All Year
Instead of treating charity like a year-end rush for tax breaks, consider using smart tools like DAFs and recurring grants for maximum impact all the year.
-
Uber Takes Aim at the Bottom Lines of Billboard Personal Injury Lawyers
Uber has filed lawsuits and proposed a ballot initiative, in California, to curb settlements it claims are falsely inflated by some personal injury lawyers.
-
A Financial Adviser's Health Journey Shows How the 'Pink Tax' Costs WomenFact: Women pay significantly more for health care over their lifetimes. But there are some things we can do to protect our health and our financial security.
-
I'm a Cross-Border Financial Adviser: 5 Things I Wish Americans Knew About Taxes Before Moving to PortugalMoving to Portugal might not be the clean financial break you expect due to U.S. tax obligations, foreign investment risks, lower investment yields and more.
-
Show of Hands: Who Hates Taxes? The Best Time to Plan for Them Is Right NowBy creating a tax plan, you can keep more of what you've earned and give less to Uncle Sam. Here's how you can follow the rules and pay only your fair share.
-
'Smart' Estate Planning Can Cause Huge Problems: An Expert Unravels Popular MythsSometimes no plan at all could be better than making these unfortunate mistakes. Don't let your best intentions mess things up for your heirs.
-
I'm a Financial Literacy Expert: Bubble-Wrapping Our Kids Robbed Them of Resilience. Now What?By raising them to think they're amazing no matter what and lifting them over obstacles, we left them unprepared to work in the real world.
-
I'm a Financial Planner: If You're a High Earner, You Need an 18-Month Safety NetNo job seems to be safe in this age of AI. If you make a larger-than-usual salary, then you need to have a larger-than-usual emergency fund. Here's why.
