How are Annuities Taxed

September 23, 2021

Annuities are becoming a more prevalent retirement planning vehicle being considered by financial advisers, and insurance professionals alike. One of the considerations to consider is the taxable consequences of the annuity from a planning standpoint. So, how are annuities taxed?

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If you purchase an annuity with pre-tax dollars, payments from the annuity are fully taxable income. If you were to buy an annuity with after-tax dollars, you are then required to pay taxes only on the earnings. Annuities will offer tax-deferred growth, which means the taxes on annuities aren’t due until you withdraw, money from the annuity.

One of the main tax advantages of annuities is they allow investments to grow tax-free until the funds are withdrawn. This includes dividends, interest, and capital gains, all of which may be fully reinvested while they remain in the annuity. This allows your investment to grow without being reduced by tax payments. This seemingly simple perk is accompanied by a number of complicated rules about what funds are taxed, how they are taxed, and when they are taxed. Because of the complexity, it’s best to consult a tax professional when purchasing an annuity and before an annuity and before withdrawing funds,

Are Annuities Taxable?

Annuities are tax-deferred. But that doesn’t mean they’re a way to avoid taxes completely. What this means is taxes are not due until you receive income payments from your annuity. Withdrawals and lump-sum distributions from an annuity are taxed as ordinary income. They do not receive the benefit of being taxed as capital gains. How taxes are determined depends on many factors centering on how the annuity was set up.

How Are Annuities Taxed?

When it comes to taxes, the most important piece of information about your annuity is whether it is held in a qualified or non-qualified account.

Qualified Annuity Taxation

If an annuity is funded with money in which no taxes have been paid, then this is a qualified annuity. Typically, these annuities are funded with money from 401(k)’s or other tax-deferred retirement accounts. Such as IRAs.

When you receive payments from a qualified annuity, those payments are fully taxable as income. That’s because you have not paid any taxes on them to date.

But annuities purchased with a Roth IRA or Roth 401(k) are completely tax-free if certain requirements are met.

Example:  Buy an annuity for $100,00 using money from a regular 401(k)———–Get $6,000 in annual payments from the annuity————Report entire amount to the IRS as taxable income in the year in which it was received.

Non-Qualified Annuity taxation

If the contract was purchased with after-tax funds- meaning the money has been reported to the IRS and taxed. This is a non-qualified annuity. Non-qualified annuities only will only pay taxes on the earnings.

The amount of taxes on non-qualified annuities is determined by the exclusion ratio. The exclusion ratio is used to determine what percentage of annuity income payments are taxable and how much is not. The idea is to determine the amount of a withdrawal or payment from an annuity is from the already-taxed principal and how much is considered taxable earnings.

The exclusion ratio involves the principle that was used to purchase the annuity, the amount of time the annuity has existed, and the interest earnings.   The exclusion ratio considers life expectancy.

If an annuitant lives longer than his or her actuarial life expectancy, any annuity payments received after that age are fully taxable.

That’s because the exclusion ratio is calculated to spread principal withdrawals over the annuitant’s life expectancy. Once all the principal has been accounted for, any remaining income payments or withdrawals are considered to be from earnings.

Exclusion Ratio Example

  • Your life expectancy is 10 years at retirement.
  • You have an annuity purchased for $400,000 with after-tax money.
  • Annual payments of $4,000-10% of your original investment is non-taxable.
  • You live longer than 10 years.
  • The money you receive beyond that 10-year-life expectation will be taxed as income.

Annuity Withdrawal Taxation

How and when you withdraw funds from your annuity also affects your tax bill.

In general, if you withdraw money from your annuity before you turn 59.5, you may owe a 10 % penalty on the taxable portion of the withdrawal.

Please reach out to the annuity team at Pinnacle Financial Services with any questions at 800-772-6881 x-6003 or email annuity@pfsinsurance.com.

For more information, contact a Pinnacle Financial Services representative today

1 (800) 772-6881 x7731 | sales@pfsinsurance.com

Will Torrance

Will Torrance

Senior Sales Director | Life, Annuity, & LTC

x7790 | wtorrance@pfsinsurance.com

Contact a Pinnacle Representative if you have any questions.

1 (800) 772-6881


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