How Are Annuities Taxed?
The answer is, unfortunately, “it depends.” The tax rules vary based on the type of annuity you purchase and how you ultimately decide to take your money. There are two broad categories of annuities: 1) immediate and 2) deferred. In a simple way, let’s look at how these products are taxed.
With an immediate annuity, you hand over the principal to an insurance company and receive. If you purchase this annuity with after-tax money, then a portion of every payout represents a return of your original investment, and a portion is considered to be taxable earnings.
When you buy an annuity and use pretax money from an IRA or a 401(k) to purchase that product, then all payouts will be fully taxed.
However, if you use after-tax money to purchase an annuity, a portion of the payouts will be a tax-free return of your principal. Regardless, you will have to pay any taxes that you owe on the annuity at your ordinary income-tax rate, not based on the capital-gains rate.
The money you invested in the annuity is returned in equal tax-free installments over the course of the payout period. If you have a life annuity with payouts that will stop when you pass away, that payment period is based on the IRS’s life-expectancy number for someone your age. You will owe taxes only on any portion of each payout beyond the tax-free return of principal.
For one last example, say you invest $100,000 in an annuity and the payouts are $8,000 per year. If the IRS considers your life expectancy to be 20 years, you would divide $100,000 by 20 to determine how much of each payout will be a tax-free return on your investment. In this case, $5,000 of each $8,000 payout would be tax-free and the $3,000 would be taxed at ordinary income-tax rates.
On the other hand, if you have a deferred annuity, you may not be receiving any payouts for quite some time. What usually happens here is you invest money while you’re still working, and that money grows tax-deferred in the account until you need it in your retirement years. You are only taxed when you withdraw money from the annuity.
For example, say that you invest $50,000 in a deferred annuity and the investments increase in value by $25,000, making the account worth $75,000. The first $25,000 you withdraw is considered to be taxable earnings, so you will pay taxes on all of the withdrawals up to that level before you can withdraw the original $50,000 investment without taxes.
Have questions? Set up a call with our dedicated retirement experts who would be happy to discuss in more detail how Kindur’s Assured Income can help make your retirement planning simpler, as well as answer your most important retirement questions.
To read more about how annuity payments and distributions are taxed, visit our articles here.