How Is an Annuity Taxed?

Kevin Dyreson is a senior director of risk product positioning at Northwestern Mutual.

Many of the financial tools that you use for retirement have complicated tax rules. For example, the money you put in 401(k)s, Roth accounts and nonqualified investment accounts will be taxed at some point. The details depend on the type of account, how long you’ve held your money in the account, and possibly even how much income you make.

Another tool often included in a diversified retirement plan is an annuity. Annuities can help you save for retirement or generate a guaranteed lifetime income after you retire. They can also help protect you from the risk of outliving your money. Let’s look at annuity taxation—but first, let’s review some annuity basics.

What is an annuity?

To understand how annuities work, keep in mind that there are different types of annuities. They fall into two main categories: annuities that help you save for retirement over time and annuities that help you create income in retirement.

Annuities that help you save for retirement are known as accumulation annuities and are designed to grow in value over time at either a fixed or variable rate. While fixed rate annuities grow in a dependable way, variable annuities could increase or lose value. That’s because a variable annuity is invested in underlying investment funds. Both of these annuities give you the option to make periodic withdrawals or create guaranteed lifetime income.

Generally, annuities that pay you a regular stream of periodic payments are known as income annuities and are often purchased at or near retirement. How much income you can expect depends on a variety of factors, including how much money you put into the annuity, when you purchased it, and how long you’re expected to live after you start taking payments. Payments can start soon after buying the income annuity, or you can defer the start of the payments. The longer an insurance company holds your annuity before payments begin, the greater the income will be.

How is an annuity taxed?

First, some good news: All annuities grow tax-deferred, meaning that you don’t have to pay any taxes until you take money out. This is known as a “distribution” and is either through a regular payment from an income annuity or a withdrawal from an accumulation annuity. Unlike nonqualified investment accounts or savings accounts that are subject to annual taxation, the growth in an annuity is not taxed until a distribution occurs. This tax deferral means your money can grow faster through compound growth because taxes will not be taken from your account value.

While the money in an annuity will grow tax-deferred, once you start withdrawing your money, all or a portion of that withdrawal will become taxed as ordinary income.

When it comes to taxes on the money you paid into your annuity, the taxation depends on how you funded the annuity. There are two types of annuity accounts, qualified and nonqualified.

• Qualified annuities are those purchased through a qualified plan like a 401(k) or SIMPLE IRA and are normally paid for with pre-tax dollars. In this case, the tax rules governing qualified plans and traditional IRAs essentially override the annuity tax rules. This generally means that the full annuity payout is taxed as ordinary income. So, the exact amount of tax depends on your federal tax bracket. For example, you might take $25,000 from a qualified annuity and be in the 22 percent tax bracket. You would pay 25,000 x .22, or $5,500. (And it may be less because the U.S. income tax system is a progressive tax, not a flat tax.)
• Nonqualified annuities are funded with money that has already been taxed. And because the money you put in was already taxed, only the growth portion of your annuity is subject to taxation. The principal (or basis)—the money you put in—will be returned to you tax-free, while the earnings growth will be taxed as ordinary income.

The IRS determines what portion of your payout will be taxed depending on whether payments are being made from an income annuity or from an accumulation annuity. And the company you bought the annuity from will typically send you a 1099-R form to report the taxable portion of the distribution. (Speaking of the IRS, you can read the latest IRS annuity rules in publication 575.)

How are distributions from accumulation annuities taxed?

With accumulation annuities, how you funded the annuity again comes into play.

For qualified annuities: Again, the tax rules for qualified plans and IRAs trump the rules for a nonqualified annuity. If all contributions were made pre-tax, as they usually are in this context, then you will owe ordinary income tax on any withdrawal or distribution.

For nonqualified annuities: You won’t owe tax on the amount you paid into the annuity. But you will owe ordinary income tax on the growth. And when you make a withdrawal, the IRS requires that you take the growth, or your gains, first. This means you will owe income tax on withdrawals until you have taken all the growth. Once the growth portion has been exhausted, you’ll start receiving funds tax-free from the principal, or basis.

One strategy to avoid paying taxes on all of your growth first is to annuitize all or a portion of your annuity. Annuitization is a feature within annuity contracts that allows you to spread the tax on your gains over your life expectancy through something called an “exclusion ratio.” This simply means the income stream you create will be made up of a portion of your gains as well as a portion of your basis. This will continue until all of the basis has been paid out. After that point, all of the payments will be treated as ordinary income.

For both types of annuities: The IRS considers annuities retirement vehicles, and as a result, an early withdrawal or distribution could trigger a tax penalty. If the owner of the account or contract is younger than 59½ years old and withdraws funds from an annuity, the taxable portion of the withdrawal could be hit with a 10 percent tax penalty.

Per the IRS, there are several situations that won’t trigger the penalty, including taking a distribution when the owner dies or becomes disabled. And it normally doesn’t apply if an income annuity is paid for life.

How are distributions from income annuities taxed?

The taxation of income annuities is based on something called the “exclusion ratio.” It’s a calculation that factors in how much you paid into the annuity, how much it has earned, and how long payments will last (which generally is your life expectancy if it is a life-based income annuity).

Let’s say you have an income annuity and are expected to live to age 90. The regular payouts are structured to spread out the principal and earnings until you’re 90. The principal portion of your payment is tax-free and divided equally among your expected payments, while the earnings portion is taxed as ordinary income.

But maybe you live to age 95. During those “extra” five years, your full payouts will be taxed as ordinary income because the principal has run out.

It’s a good idea to work with your financial and tax advisors before taking a withdrawal from an annuity to understand how your taxes and your retirement income could be impacted. And if you’re thinking about purchasing an annuity, your Northwestern Mutual financial advisor can help you understand how one could fit into your financial picture.

Withdrawals are pursuant to possible contract limitations/adjustments and IRS tax rules.

Annuities are contracts sold by life insurance companies and are considered long-term investments that may be suitable for retirement. Income annuities (either immediate or deferred) have no cash value, and once issued they can’t be terminated (surrendered). The original premium paid is not refundable and cannot be withdrawn.

All guarantees associated with annuities and income plans are backed solely by the claims-paying ability of the issuer.

All investments carry some level of risk, including potential loss of principal. Withdrawals from variable annuities may be subject to ordinary income tax, a 10% IRS penalty if taken before age 59½, and contractual withdrawal charges.