How Annuities Are Taxed

As most people know, one of the benefits of an annuity is that it is tax-deferred. It allows the investors to earn interest and gains each year without having to declare them since you are inside an annuity. Annuities are often purchased with after tax money. This feature saves your initial investment from tax deductions on your income tax return. However, this does not apply if you are purchasing the annuity as a part of an IRA or other tax qualified accounts, as those benefits are already in place due to the nature of the account. Another benefit is that if you decided to change your annuity from one company to another that offers better benefits / rates  or has been performing better, you can do a tax-free 1035 exchange of your annuity without having to pay taxes on any gains. However, you have be aware of surrender charges and compare the surrender period on the new contract.

Annuities can be taxed in several ways. Mainly, you will be taxed on any type of distribution.  In this stage, withdrawals will be taxed on a LIFO basis or known as last-in-first-out cycle.  This means that the distribution will be considered the earnings or gains first then principal will go last. The interest
will be taxed as an ordinary income until it has all been distributed, then, the principal will be returned without being taxed.  For example, if your annuity is $100,000 and your initial investment is $50,000, the other $50,000 is your interest which will be the taxed. If you decided to make lump sum withdrawals
before you reached 59 1/2, you will have to pay 10% early withdrawal tax.

Annuities will be taxed when you elect to receive income payments or annuitize the contract. The portion that is considered as your interest will be taxed as an ordinary income while the principal will not be taxed.  However, be advised that once you’ve annuitized your annuity, you are no longer able to make any changes since it was converted to income for certain period of time. You will also be taxed on the total amount gained in your annuity if you transfer your ownership to another person.

Death benefit payouts are taxed the same as the lump sum withdrawal. The earnings or interest will be taxed as ordinary income while the remaining will be tax free.  However, it also depends on the structure of the annuity death benefits.  In some companies, the beneficiary has option to receive it as a lump sum or annual or monthly payments in a certain period of time. However, the value of the entire annuity is considered as part of the annuitant’s estate which means that the beneficiary will still have to pay the inheritance tax. 

 Annuity taxation may sound complicated, but it is important that we understand it before purchasing a certain type of annuity.  You can seek advice from the annuity representative or advisor for more information to help you get the most of the annuity benefits.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.