Annuities have special features and tax benefits to help you save for retirement. However, it's also important to be aware of annuity tax rules and how they will impact you if you choose this investment option. While the benefits outweigh the drawbacks for many people, annuities aren't the right choice for everyone.
Fortunately, an independent insurance agent can help you determine if an annuity is right for you. They can help you better understand annuity tax implications and how much you can expect to gain from your investment. But first, you can use our guide to learn how much tax you pay on an annuity and more.
Key Takeaways - How Are Annuities Taxed?
- Annuity growth is tax-deferred, meaning you don't pay taxes on the money as it's accumulating.
- You only pay taxes on annuities when you go to withdraw the funds.
- Even inherited annuities are taxed, but there are ways you can defer these payments.
- It's highly recommended to work with an independent insurance agent, as they can help you understand your options and find an annuity plan that works best for you.
Are Annuities Taxable?
Yes, annuities are taxable, but there is an important caveat to understand. An annuity's growth is tax-deferred, which means that you won't pay any taxes on the money as it accumulates. You do pay tax on annuity withdrawals, meaning when you take your money out. So if you've been asking, "Do you pay taxes on annuities?" the answer is yes, but not until you go to withdraw your funds.
How Taxes on Traditional Qualified Annuities Work
Traditional qualified annuities are part of traditional pension plans and IRAs. Contributions to traditional qualified annuities are made with pre-tax dollars. Generally, proceeds received from traditional qualified annuities are 100% taxable at ordinary rates.
Loans and sales are not permitted from an IRA. Loans may be available from a traditional qualified annuity in a pension if the proceeds are used to purchase a home or are repaid within five years. Loan proceeds are not taxable under the exceptions.
How Taxes on Roth Plan Qualified Annuities Work
Roth plan qualified annuities are part of Roth pension plans and IRAs. Usually, proceeds received from them are tax-free.
How Taxes on Non-Qualified Annuities Work
Non-qualified annuities are personally owned by the investor and paid for with after-tax dollars. They are taxed at ordinary income rates.
Are Annuity Payments Taxable Income?
Annuity income is partially taxable. The amount of the annuity payment that is considered principal is excluded from taxable income. The exclusion is calculated based on the expected number of payments. Withdrawals are taxed as interest first until the growth is exhausted.
Loans are taxed as withdrawals. Surrenders are taxed based on the surrender value minus total interest paid.
Understanding Annuity Penalty Taxes
Traditional qualified, Roth-qualified, and non-qualified annuities all have a 10% penalty tax for withdrawals before age 59.5. Each plan also has a 10% penalty for withdrawals taken before the end of five years.
When Do You Pay Taxes on an Annuity?
When you pay depends, because taxes on annuities work differently depending on the type of account you choose. Here's a closer examination of the tax impact for different types of annuity plans and transactions.
| Non-Qualified | Qualified | Qualified/Roth | |
|---|---|---|---|
| Contributions | After-tax, unlimited | Pre-tax, limits for IRAs and qualified plans apply | After-tax, limits for IRAs and qualified plans apply |
| Growth | Tax-deferred | Tax-deferred | Tax-deferred |
| Surrender | Gain is taxed at ordinary rates. | All proceeds taxable | Tax-free |
| Annuity Income | Partially taxable at ordinary rates | 100% taxable at ordinary rates | Tax-free |
| Withdrawals | Withdrawals are gain first, gain is taxed at ordinary rates. | 100% taxable at ordinary rates | Tax-free |
| Loans | Loans are considered withdrawals; gain first is taxed at ordinary rates | IRA loans are not permitted; pension plans may have exceptions for home purchase and loans repaid in five years | IRA loans are not permitted; pension plans may have exceptions for home purchase and loans repaid in five years |
| Death Benefits | Gain is taxed at ordinary rates; proceeds will be taxed as "gain first" | Rules for inherited traditional IRAs and qualified plans apply | Rules for inherited Roth IRAs and plans apply |
| Sales | Proceeds in excess of the basis are taxed at ordinary rates | N/A | N/A |
| Penalties | 10% for withdrawals before age 59-1/2 | 10% for withdrawals before age 59-1/2 | 10% for withdrawals before age 59-1/2, penalty for withdrawals prior to the end of the fifth year |
Is an Inherited Annuity Taxable?
Yes, inherited annuities are taxable. The way your inherited annuity is taxed is determined by your beneficiary status and how you choose to receive the payouts. For spouses of the original annuitant, payments can continue to be received according to the annuity's original schedule. In such a case, taxes would be deferred until you choose to receive the annuity's distributions.
Is a Lump Sum Annuity Taxable?
Yes, a lump sum annuity is also taxable. A lump sum annuity refers to an inherited annuity in which the beneficiary opts to withdraw any money remaining in the account in one lump sum. When the beneficiary withdraws the funds, they are taxed on the benefits received.
How to Avoid Taxes on Annuities
You can't avoid paying taxes on an annuity, even if you've inherited it. However, there are ways you can defer the taxes owed on an annuity you inherit. You can use the 1035 exchange method to exchange the annuity you inherited for another type of annuity, or you can roll the inherited annuity over into an IRA.
This option is only available if you inherited the deceased annuitant's IRA, as well. Ask your independent insurance agent about your options for deferring or minimizing any taxes owed on an inherited annuity.
An Independent Insurance Agent Can Help You Find the Right Annuity
Annuities are financial tools that offer tax-deferred growth and, in some cases, tax-favored income. Be sure to consult your professional advisor for tax and legal advice.
Additionally, you'll want to work with an independent insurance agent to find the right kind of annuity. Your agent has access to multiple companies, so they're free to shop and compare annuity options and rates for you. They can also help you understand exactly how and when your annuity will be taxed so you can make an informed choice.
Sources
https://smartasset.com/financial-advisor/how-to-avoid-paying-taxes-on-an-inherited-annuity
https://www.northwesternmutual.com/life-and-money/how-is-an-annuity-taxed/
https://www.westernsouthern.com/retirement/how-are-annuities-taxed
