Advertisement
taxes

How an Annuity Is Taxed

Timing is important when it comes to defining how you're going to take -- and be taxed on -- annuity income.

The conventional advice is to avoid investing in a deferred annuity within a tax-deferred retirement account because the retirement account already has the benefits of tax deferral. But now that more people are buying annuities for their lifetime income guarantees rather than their tax benefits, investing in immediate or deferred income annuities within retirement accounts is gaining popularity.

Taxable annuity payouts are always taxed at your ordinary income tax rate—not the lower capital gains rates. If your annuity is in a traditional IRA, 401(k) or retirement account in which all of your contributions were pretax or tax-deductible, all of the payouts will be taxed as ordinary income. (If the annuity is in a Roth IRA, all of the withdrawals will be tax-free as long as you’ve had the Roth for five years and are over 59½.) If you have a deferred-income annuity in a tax-deferred retirement plan and have to take required minimum distributions at age 70½, you may not be able to defer payouts past that age.

Advertisement - Article continues below

If you invested after-tax money in the annuity, the way you take the money can make a big difference. If you have an immediate annuity or if you choose to convert a deferred annuity into a lifetime income stream (called “annuitizing”), then a portion of each payout is considered to be a tax-free return of principal and a portion is taxable earnings. The principal is returned in equal tax-free installments over the payout period. If you have a life annuity with payouts that stop when you die, for example, then the payout period is the IRS’s life-expectancy number for someone your age. Divide your contributions by that life-expectancy number, and you’ll owe taxes only on the portion of each payout beyond that. (If you live longer than the IRS tables anticipate, you’ll owe tax on 100% of each payment after you have recovered your investment.)

Advertisement
Advertisement - Article continues below

If you take deferred annuity withdrawals on your own, instead of locking in lifetime income, all of the early payouts are considered taxable earnings, and payouts after that are treated as a tax-free return of principal. If you withdraw the money in a lump sum, then you owe taxes on the difference between your original contributions and the amount you receive when you cash out.

Advertisement

Most Popular

2020 Stock Market Holidays and Bond Market Holidays
Markets

2020 Stock Market Holidays and Bond Market Holidays

Is the market open today? Take a look at which holidays the stock markets and bond markets take off in 2020.
July 1, 2020
What Are the Income Tax Brackets for 2020 vs. 2019?
tax brackets

What Are the Income Tax Brackets for 2020 vs. 2019?

The IRS unveiled the 2020 tax brackets, and it's never too early to start planning to minimize your future tax bill.
June 20, 2020
Searching for the Perfect Place to Retire
Empty Nesters

Searching for the Perfect Place to Retire

We home in on two places with less traffic and lower costs. 
July 2, 2020

Recommended

20 IRS Audit Red Flags
tax returns

20 IRS Audit Red Flags

There's no sure way to avoid an IRS audit, but these red flags could increase your chances of drawing unwanted attention from the IRS.
July 1, 2020
10 IRS Audit Red Flags for Retirees
retirement

10 IRS Audit Red Flags for Retirees

Watch out: These things can increase the chances that the IRS will give your tax return a closer look.
July 1, 2020
10 Tax Breaks for the Middle Class
tax deductions

10 Tax Breaks for the Middle Class

Tax breaks aren't just for the rich. There are plenty of them that are only available to middle- and low-income Americans.
June 30, 2020
What to Do If You Get a Stimulus Check for a Deceased Person
taxes

What to Do If You Get a Stimulus Check for a Deceased Person

The IRS sent more than 1 million stimulus checks to dead people. If you received one for a family member who passed away, there are certain steps you …
June 25, 2020