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Guide to annuity taxation

When searching for opportunities to create reliable income in retirement, you may have discussed the potential benefits of purchasing an annuity with a financial professional. One important consideration when researching annuities is how they can impact yo ur tax situation in retirement.

Even among different annuities, the tax treatment differs. Here鈥檚 what you need to know about making tax-conscious decisions when purchasing an annuity. 

How are annuity withdrawals taxed?

When receiving payments from your annuity, you will likely owe ordinary income tax to the IRS on all or a portion of the income. If you have a non-qualified annuity, for example, your tax liability extends only to the portion of the withdrawal that comes from earnings or growth, either from interest accrued or investment returns. "Non-qualified" means the annuity was funded with money on which you've already paid federal income tax.

However, if your annuity is purchased within your tax-deferred retirement plan (like an IRA or 401(k)), you will be responsible for paying ordinary income tax on the entire payment. This is because tax-deferred plans are funded with pre-tax dollars, meaning neither your contributions nor the growth has yet been subject to tax.

Do annuity withdrawals affect Social Security benefits?

No, the Social Security Administration does not count annuity income as earnings. Your withdrawals will not lower or otherwise impact your Social Security retirement benefits. 

What is a premium tax when purchasing an annuity?

A premium tax refers to a sales tax imposed on insurance premiums (like an insurance tax), including those on annuities, determined at the state level. Tax rates and timing for payment may depend on the state and the product. 

Qualified vs. non-qualified annuities

A qualified annuity is funded with pre-tax contributions, while a non-qualified annuity is established using after-tax dollars.

Qualified annuities are opened through a tax-deferred retirement account such as a 401(k), 403(b), or IRA. They are considered 鈥渜ualified鈥� by the IRS because they鈥檙e built into a qualified retirement plan. Keep in mind that if you withdraw funds from a qualified annuity before age 59 陆, the income may be subject to early withdrawal distribution penalties of 10% in addition to your ordinary income tax. 

Non-qualified annuities, with some exceptions, also are subject to a 10% early withdrawal penalty. How your withdrawals from non-qualified annuities are taxed can depend on factors including the exclusion ratio and the last-in-first-out (LIFO) rule. 

What is the exclusion ratio?

The exclusion ratio helps you determine how much of your non-qualified immediate annuity income is not subject to taxation. For immediate annuities, you can find the exclusion ratio by dividing the amount you put into the annuity by the total expected payout. This can show you what portion of your withdrawals is taxable and what portion is tax-free, based on your initial premium (or principal), life expectancy, and expected returns.

Here's an example: Suppose you buy an annuity with a lump sum. In exchange, you receive monthly payments for the next 20 years. Over that time, your initial premium is expected to grow, which means the total payments will likely add up to more than your initial lump sum payment.

For taxes, the IRS says you need to spread your initial premium evenly over the 20 years of payments. So, each monthly payment will include some of your original premium, which is not taxed again. Only the part of the payment that comes from growth (earnings) is taxable as regular income.

What is the last-in-first-out tax rule?

The last-in-first-out (LIFO) tax rule is used to determine how annuity payments are taxed on deferred non-qualified annuities. 

Put simply, the LIFO tax rule says earnings in the annuity are taxed before the principal contribution. As a result, your earlier withdrawals will likely have a higher tax bill than your later withdrawals. Once your withdrawn income exceeds your earnings, any payments received after are tax-exempt, since they鈥檙e presumed to be part of the principal amount, unless additional interest is earned.

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Income tax can affect your purchasing power in retirement, which means it鈥檚 important for you to consider how your future annuity payments may be taxed. By considering the tax treatment of qualified and non-qualified annuities, you and your financial professional can more effectively build a retirement income plan that helps minimize your lifelong tax obligations. 

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Any information regarding taxation contained herein is based on our understanding of current tax law, which is subject to change and differing interpretations. This information should not be relied on as tax, legal, or financial advice and cannot be used by any taxpayer for the purposes of avoiding penalties under the Internal Revenue Code. We recommend that taxpayers consult with their tax or legal professionals for applicability to their personal circumstances.