For financial advisers, annuities can play a critical role in providing clients with dependable retirement income and confidence.
However, understanding their tax implications is essential to helping ensure optimal client outcomes. Proper planning around annuity taxation helps prevent surprises and supports the overall goal of financial security annuities aim to deliver.
By diving into key aspects of annuities and their tax consequences, advisers will be better equipped to make these unique retirement income tools work smarter for clients.
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Types of annuities and their tax profiles
Annuities come in several forms, and their tax treatment varies significantly. Here’s what financial advisers need to know about the main types.
1. Qualified annuities
What they are. Funded with pre-tax dollars via tax-advantaged accounts like 401(k)s, 403(b)s and traditional IRAs.
Tax treatment:
- Contributions are tax-deductible
- Earnings grow tax-deferred, but withdrawals are taxed as ordinary income
- Required minimum distributions (RMDs) begin at age 73 (or 75 for those born after 1960)
- Withdrawals before age 59½ incur a 10% penalty, unless an exception applies
2. Non-qualified annuities
What they are. Purchased with after-tax dollars, making them more flexible but subject to distinct tax rules.
Tax treatment:
- Principal withdrawals are not taxed (as they’ve already been taxed), but earnings are
- Distributions follow the last-in, first-out (LIFO) rule, meaning taxable earnings come out first
- No RMDs are required, though certain events may trigger mandatory distributions
3. Roth annuities
What they are. Held within a Roth IRA or Roth 401(k), combining the guarantee of annuities with the tax advantages of Roth accounts.
Tax treatment:
- Contributions are post-tax, earnings grow tax-free and qualified distributions (after five years and age 59½) are entirely tax-free
- Non-qualified distributions of earnings may incur taxes and penalties
Pro tip: Strategically blending clients’ portfolios with a mix of tax-deferred (qualified) and tax-free (Roth) products creates powerful tax diversification for retirement.
Tax implications at the distribution stage
When it’s time to tap into annuities, the tax considerations shift. Advisers should familiarize themselves with how distributions are treated to help clients avoid surprises.
1. Partial withdrawals
- Non-qualified annuities. These are taxed on a LIFO basis, meaning amounts withdrawn consist of taxable earnings first, then non-taxable principal
- Qualified annuities. Withdrawals are fully taxable unless the account includes after-tax contributions, in which case distributions are taxed pro-rata
2. Annuitized payments
Once annuities are converted into a stream of regular income, the tax picture changes. Annuity payments are typically divided into two portions:
- A return of principal (non-taxable)
- Earnings (taxable as ordinary income)
The exclusion ratio helps determine how much of each payment is taxable by dividing the principal (investment in the contract) by the expected total return of the annuity.
2. RMD rules for qualified assets
- RMDs apply to qualified annuities, starting at age 73 (or 75 depending on birth year). Missing an RMD incurs steep penalties — up to 25% of the missed amount, reduced to 10% under certain correction conditions introduced by the SECURE 2.0 Act.
- SECURE 2.0 allows annuitized payments to satisfy RMD requirements, offering flexibility for clients using annuities in their portfolio.
4. Early-withdrawal penalties
If clients under 59½ need access to funds, a 10% penalty tax applies — unless exceptions (such as disability or medical expenses) are met.
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Advisers can deploy strategies like substantially equal periodic payments (SEPPs) that spread withdrawals over time while avoiding penalties.
Strategies to optimize tax efficiency
1. Roth conversions
Converting traditional IRAs into Roth IRAs allows for tax-free distributions later. Advisers should focus on low-income years or market downturns to execute conversions at minimal tax cost.
Example: A client converts $50,000 of a traditional IRA in a low-income year, ensuring all future distributions (including from annuities in that Roth) are tax-free.
2. Tax diversification
Advisers should consider structuring portfolios with three tax buckets:
- Taxable (e.g., investment accounts) for near-term liquidity
- Tax-deferred (traditional annuities, IRAs) for lower-tax-rate years
- Tax-free (Roth IRAs or Roth annuities) for legacy goals or high-tax-rate periods
Clients with this diversification can adjust distributions based on tax brackets, creating more retirement income with less tax exposure.
3. Addressing RMDs
Advisers can optimize RMDs by considering annuitized income streams, moving eligible balances between plans or taking distributions earlier to mitigate concentrated withdrawals in later years.
4. Leveraging 1035 exchanges
Non-qualified annuities gain flexibility from 1035 exchanges, which allow tax-free transfers to new contracts that better align with a client’s changing goals.
For example: Moving from deferred annuities to immediate annuities for guaranteed income in retirement.
Common tax pitfalls and missteps
Financial advisers should help clients steer clear of these major errors:
- Failing to track after-tax contributions. Without IRS Form 8606, returns of basis may be overtaxed.
- Mismanaging aggregation rules. Clients owning multiple annuities from one insurer may inadvertently aggregate distributions, complicating their tax treatment.
- Missing RMD requirements. Clients not aware of their obligations (or updated SECURE 2.0 provisions) risk substantial penalties, jeopardizing retirement cash flow.
Quick insight: Taking more than the RMD in one year doesn’t offset the next year’s withdrawal requirement — it only reduces the account balance used to calculate future RMD amounts.
Actionable adviser takeaways
- Stay current with tax legislation. SECURE 2.0 changed the landscape for retirement accounts. Knowledge of these provisions helps advisers guide clients toward better decisions.
- Create a tax diversification strategy. A balanced mix of taxable, tax-deferred and tax-free accounts helps reduce the risk of future tax shocks.
- Be strategic with annuitization. Use single premium immediate annuities (SPIAs) and other annuity products to complement and satisfy RMDs while providing stable income.
- Partner with tax experts. Collaborate with CPAs to handle complex cases like Roth conversions, 1035 exchanges or legacy planning strategies involving inherited annuities.
Final thought
Understanding the intricacies of annuity taxation allows financial advisers to build better, more resilient retirement portfolios for clients.
With proper planning, annuities can provide both lifetime income and confidence as clients become confident in the knowledge that their tax impact is fully considered and accounted.
Investing involves risk, including the potential loss of principal. Any references to protection, safety or lifetime income, generally refer to fixed insurance products, never securities or investments. Insurance guarantees are backed by the financial strength and claims paying abilities of the issuing carrier. Our firm is not affiliated with the U.S. government or any governmental agency. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. Please remember that converting an employer plan account to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences. Be sure to consult with a qualified tax adviser before making any decisions regarding your IRA. 4317283 – 3/25
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