How To Avoid Paying Taxes On Your Annuity

An annuity is a financial product offered by insurance companies. It often appeals to risk-averse investors or those who have maxed out their retirement accounts. One key advantage of an annuity is the lack of contribution limits, unlike 401(k)s and IRAs. Additionally, earnings grow tax-deferred, allowing for potential long-term growth without immediate tax liabilities. If you’re considering an annuity for retirement income or as an additional investment, we’ll cover what you might want to consider regarding annuities and taxes. 

You can also consider consulting with a financial advisor for help in determining if it’s the right fit for your financial goals.

Annuities and Taxes

Purchasing an annuity is a tax-deferred way of increasing your retirement savings. It’s a contract between you and an insurance company that will pay you regular payments either beginning at the time of purchase or at some point in the future. This can help increase and protect your retirement savings.

There’s no limit on how much you can contribute to an annuity, unlike a 401(k) or an individual retirement account (IRA). Annuities do have the same early withdrawal taxation rules as other retirement accounts, though. If you make a withdrawal, you’ll be subject to taxes and a 10% early withdrawal penalty.

One of the advantages of buying an annuity is that the earnings are allowed to grow on a tax-deferred basis until withdrawal. Earnings include interest, dividends and capital gains. The earnings are reinvested each year without any tax impact. However, there are disadvantages, including the rate at which you’re taxed.

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Taxation on Qualified Annuities

How annuities are taxed depends on whether your account is a qualified or a non-qualified account. A qualified annuity is one that has been purchased with pre-tax dollars. If you use the money from a 401(k), 403(b), traditional IRA, SEP-IRA or SIMPLE IRA to purchase an annuity, it will be classified as a qualified annuity. This is because those are all funded with pre-tax dollars.

The payments from this type of annuity are fully taxable as ordinary income, but not until you make a withdrawal or start receiving payments. If you make an early withdrawal, however, you may have to pay your full contribution to the annuity, plus the 10% penalty.

Taxation on Non-Qualified Annuities

Non-qualified annuities are purchased with after-tax dollars, meaning you’ve already paid income tax on the funds used to buy the annuity. When you begin taking withdrawals, the portion of your payment that represents a return of your original investment (principal) is not taxed again. Only the earnings portion, interest, dividends and capital gains, is taxable as ordinary income.

Withdrawals from a non-qualified annuity are taxed using the exclusion ratio, which separates each payment into a taxable and non-taxable portion. The taxable part represents earnings, which are deferred until withdrawn.

If you take a withdrawal before age 59½, the taxable portion is also subject to a 10% early withdrawal penalty, unless an IRS exception applies. This penalty is applied on top of ordinary income tax on the earnings.

Unlike mutual funds or taxable brokerage accounts, where earnings are taxed annually, non-qualified annuities offer tax deferral. You don’t pay tax on earnings until you withdraw them. However, when you do, those earnings are taxed at ordinary income rates, not capital gains tax rates. 

Additionally, non-qualified annuities don’t allow for Roth conversions, which limits future tax planning flexibility.

Taxation of Other Classifications of Annuities

There are also immediate and deferred annuities, and fixed and variable annuities, each with their own way of functioning. Here’s a look at how these other types of annuities are taxed:

• Fixed and variable annuities.Both offer tax-deferred growth, meaning you don’t pay taxes on earnings until you withdraw them. A fixed annuity pays a guaranteed interest rate and isn’t affected by the market, while returns on a variable annuity depend on market performance. Both types of annuities are taxed in the same way: Earnings are taxed as ordinary income when withdrawn, and early withdrawals before age 59½ may also trigger a 10% penalty.
• Immediate and deferred annuities. An immediate annuity is usually purchased with a large contribution, and payout begins immediately and may last as long as you live. A deferred annuity offers payout at some point in the future, allowing for interest to accrue on your contributions. For both these types of annuities, the earnings grow tax-deferred until you start taking the payouts.

How Annuities Are Taxed During the Payout Phase

Once an annuity enters the payout phase, the tax treatment of each payment depends on how the contract was funded. For qualified annuities, every dollar of the payment is taxable because all contributions were made with pre-tax funds. These payments are treated as ordinary income and taxed according to your income bracket for the year.

Non-qualified annuities follow a different rule. Part of each payment represents a return of your principal, which is not taxed, and part represents your earnings, which are taxed as ordinary income. The insurer calculates the taxable and non-taxable portions using the exclusion ratio. This ratio determines how much of each periodic payment is attributed to your original investment until the entire principal has been recovered.

Once the principal portion has been fully paid out, all subsequent payments become fully taxable. This shift is important for long-term income planning, especially for lifetime annuities where payments may continue for many years after the exclusion ratio has been used up.

Taxes also depend on the payout option selected. Lifetime payouts, period-certain payouts and joint-life payouts all follow the same basic rules, but the expected payment duration affects how the exclusion ratio is calculated. Understanding how these rules apply can help annuity owners estimate after-tax income and plan for long-term cash flow during retirement.

Other Types of Annuity Taxation

If you inherit an annuity, the same tax rules apply if you are the spouse of the annuitant. You can choose to receive your payouts according to the annuity schedule. In that case, taxes are deferred until you make withdrawals or receive your payouts. If you are not the spouse of the annuitant, the tax status depends on how you choose to receive your payouts. 

When an annuity owner dies with a remaining balance, their beneficiaries must fulfill a tax obligation. The tax is based on the difference between the premiums paid and the remaining balance at the time of death. If the annuity includes a death benefit, the IRS generally treats it as taxable income, unlike life insurance payouts.

Bottom Line

Annuities can offer tax-deferred growth and flexible payout options for retirement savers who have maxed out other accounts, but their tax treatment depends on how the annuity is funded. Qualified annuities use pre-tax dollars and are fully taxed as ordinary income upon withdrawal. Non-qualified annuities, funded with after-tax dollars, only tax the earnings portion of each withdrawal. All earnings are taxed at ordinary income rates and may incur a 10% penalty if withdrawn before age 59½. 

Retirement Tips

• Saving and investing for retirement can be a difficult task, but a financial advisor may be able to help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Planning for retirement and your financial future can be intimidating, so it’s important to stay prepared. SmartAsset has you covered with a number SmartAsset’s 401(k) calculator. It helps you plan your retirement by showing you the value of your 401(k) over time.

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