Annuities can be a reliable source of income in retirement. Once you begin receiving benefits. You’ll receive a set amount of money each month or year for the rest of your life. Even if you live for decades more. However, annuities can come with tax implications. Both on the front and back ends. If you want to find out more about annuities and taxes. Here’s what you need to know.
Annuities and Taxes – Qualified vs. Non-Qualified Annuities
First, it’s important to understand that how an annuity is taxed does vary depending on the type of annuity involved, especially how it was funded.
Qualified annuities are funded with pre-tax dollars. In most cases, these involve principal payments from a type of tax-deferred retirement account, like a 401(k) or a traditional IRA. However, there may be other approaches available, as well.
When you make withdrawals from a qualified annuity, you pay taxes on the money just as you would other traditional kinds of income. Since none of the money has been taxed, every dollar in the withdrawal is treated the same.
Non-qualified annuities are funded with after-tax money. With those, when you make withdrawals, you’ll only owe taxes on earnings, not the deposited amounts. The money used to fund the annuity has already been taxed, so it won’t be taxed again. However, the earnings haven’t, making them subject to taxation.
Usually, with non-qualified annuities, the taxed amount is determined by the exclusion ratio. This calculation determines how much of an annuity income payment is taxable by separating the portion of the payment funded with the principal from the part funded by interest earnings.
In some cases, annuities purchased with funds from a Roth 401(k) or Roth IRA are tax-free. However, very specific conditions have to be met for that to happen.
Tax Rates on Annuities
When you’re receiving income from an annuity, the taxable amount is taxed based on traditional income tax rates. Annuities aren’t eligible for capital gains rates, which are often lower than income tax rates.
If you need to estimate how much you’ll owe, use the traditional tax tables from the IRS. That will give you the most accurate picture, at least on a federal level.
In some cases, you’ll also need to pay taxes on the state level. State income tax rates vary, and some may exclude annuities – as well as other kinds of retirement income – while others do not. Additionally, not all states have an income tax in the first place. As a result, you’ll need to research rules in your area to determine how much you may owe.
Depending on where you purchase your annuity, you may also owe a state premium tax. Some states tax insurance premiums, including during the sale of annuities. If you live in one of those states, you may see a 1 to 3.5 percent tax. However, some states waive the fee under certain circumstances, such as if you make the purchase using funds from a qualified retirement plan.
When Withdrawal Timing Impacts Taxes on Annuities
Another factor in how money from an annuity is taxed is when withdrawals are made. Usually, if you take any money out before you reach the age of 59 ½, you’ll owe a penalty of up to 10 percent to the IRS. However, by waiting until you’re at least 59 ½, you can avoid this entirely.
Additionally, if you take a lump sum instead of annuity income payments, at a minimum, all of your earnings are taxed right away. If you funded the annuity with pre-tax dollars, then the entire lump sum, including both the principal and earnings, are taxed immediately.
Inherited Annuities and Taxes
If you inherit an annuity from another person, the same tax rules apply to you as would to the deceased. As a result, if the annuity was qualified because it was funded with pre-tax dollars, you’ll owe taxes on the entire value of any withdrawals. If it was non-qualified, then you’ll only owe taxes on the earnings.
Ultimately, annuities are fairly simple to understand from a tax perspective. Earnings are typically taxed as income, and withdrawals from principal only are if the annuity was funded pre-tax. While your income tax rates may vary depending on your total income level, how your annuity factors in is reasonably straightforward.
Is there anything else people should know about annuities and taxes? Share your thoughts in the comments below.
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Tamila McDonald is a U.S. Army veteran with 20 years of service, including five years as a military financial advisor. After retiring from the Army, she spent eight years as an AFCPE-certified personal financial advisor for wounded warriors and their families. Now she writes about personal finance and benefits programs for numerous financial websites.