Annuity taxation depends on how the annuity is funded and how you choose to take payments. Because qualified annuities are generally funded with pre-tax dollars, the entire amount of each payment is generally taxable. With nonqualified annuities, only the portion of the payment that comes from its earnings is taxable, since the annuity was funded with after-tax dollars.
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Are annuities taxable?
Understanding when and how taxes are owed on annuity payouts is crucial when planning for retirement. Deferred annuities can help you maximize your retirement funds with tax-deferred savings.
Are annuity payments taxable?
Having a nest egg that guarantees a steady stream of income during retirement can boost your peace of mind. Qualified deferred annuities, often allow you to save pre-tax dollars for retirement and enjoy tax-deferred growth. Annuity payouts may be taxable depending on the type of annuity contract you have.
How are annuities taxed?
Taxes on annuities will depend on what type of annuity you have and how it’s funded. There are annuities that credit a fixed rate of interest to accumulate account value, and variable annuities which rely on market investments for growth. In addition, annuities can be funded with pre-tax dollars or after-tax dollars. Whether annuities were funded with pre-tax or after-tax dollars will change when and how you pay taxes on their payouts:
Taxes on qualified vs. nonqualified annuities
Annuities are funded in two primary ways that affect their taxation—qualified and nonqualified. While not always the case, qualified annuities are generally funded with pre-tax dollars and grow tax deferred. When you start taking payments from a qualified annuity, the entire amount of each payment is considered income and is subject to income taxes. However, since your income is likely to be lower in retirement than when you are funding the annuity, there can be significant tax advantages beyond the tax-deferred growth.
Nonqualified annuities also provide tax-deferred growth, but they differ from qualified annuities in that they’re funded with after-tax dollars. Since taxes were already paid on the money used to fund the nonqualified annuity, withdrawals are partially tax free. Only the tax-deferred growth of the account is taxable when you begin receiving payouts.
When do you pay taxes on annuities?
Taxes on annuities are usually due when you start receiving the payouts, or when you withdraw money from the annuity. How the payments are taxed depends on how the annuities were funded. If the annuity was funded with pre-tax (qualified) dollars, the annuity owner will pay tax on their contribution and any earnings. If the annuity was funded with already-taxed dollars, the owner will pay tax on the earnings portion of the payment.
Is annuity income taxable?
As the money used to fund your annuity grows, the taxes on the earnings are deferred. No taxes are owed on the growth until you begin taking money out of the annuity via payments or by surrendering the annuity. The tax-deferred status allows your money to grow faster, since you don’t have to remove some of your gains to pay those taxes. Once you begin receiving payments from your annuity, it is considered income and is subject to taxes.
How are annuities taxed when distributed?
Each of the periodic distributions from a qualified annuity is subject to taxes. If you surrender your qualified annuity and take the present value as a lump-sum payment, the entire payment is considered income for that year, and you’ll owe taxes on it. You may also face a 10% early withdrawal penalty tax if you are younger than age 59½. When you receive payments from a nonqualified annuity, only the earnings portion of each payment is taxable.
What if I avoid early withdrawals or lump-sum payments?
While you can’t avoid paying taxes on annuities, you can minimize your tax burden by avoiding early withdrawals and lump-sum payouts. It’s best to speak with a tax professional to make sure you receive the maximum benefits and remain in compliance with tax laws.
Is changing ownership on an annuity a taxable event?
Annuities may be taxable when they change hands. For example, a gift or sale of a nonqualified annuity contract is taxable to the original owner. However, the transfer of an annuity to a beneficiary in and of itself is not taxable. It is the beneficiary’s receipt of distributions from the contract that is taxable according to certain circumstances:
- A lump-sum payment will allow you to collect the amount that’s left in the annuity in a single payment. In this case, taxes will become due when you receive the money.
- The five-year rule lets you keep the funds in the contract for up to 5 years provided you withdraw all the money by the end of the 5-year period.
- A nonqualified stretch allows non-spousal beneficiaries to spread payment of the remaining annuity contract value and the associated tax liability over the beneficiary’s life expectancy.
The options that let you take possession of the money sooner will require a larger tax payment than those in which you access the money further in the future.
Can the beneficiary of an annuity transfer it to a new annuity?
If you inherited a nonqualified annuity, you could opt for a 1035 exchange, in which you swap one annuity for another and receive payments over your life expectancy. No gain or loss is recognized during the transfer, allowing you to avoid immediate taxation. Also, if you inherited an IRA, you could transfer the proceeds into a new Inherited IRA and receive distributions over time (up to 10 years, unless you are an eligible designated beneficiary).
Annuity taxation FAQs
Withdrawals from an annuity are taxable. The amount due depends on the type of annuity—whether it’s a qualified or a nonqualified annuity. With a qualified annuity, the entire amount of your payment is generally taxable, but with a nonqualified annuity, only the growth is taxable. It’s also worth noting that early withdrawals from an annuity are usually subject to a 10% penalty tax.
The taxable portion of annuity payments count when determining whether a portion of your social security benefits is taxable. Information on how Social Security is taxed can be found at IRS.gov.
A lump-sum payment from cashing out your annuity can trigger income-tax liabilities. An exception may occur if the annuity was funded with after-tax dollars, and there is no growth above the premiums you put in. In that case, there won’t be any taxes due.
The full amount of a qualified annuity payment is subject to income taxes if the account is funded with pre-tax dollars.
Only the portion of a nonqualified annuity payment that comes from earnings is taxable.
Yes, annuity payments are subject to income taxes. How much and when the taxes are due depend on how the annuity is structured.
Only contributions made to traditional IRAs (within limits) may be deductible if you meet certain requirements.
Federal and, if applicable, state income taxes are generally required to be withheld from annuity payments, unless you elect not to have withholding apply.
There is no age exemption for paying taxes on annuities. Many annuities provide tax-deferred growth and lifetime payments, so you can expect to pay taxes on them throughout your retirement years.
Interested in how annuities can strengthen your financial strategy?
A New York Life financial professional can help you weigh the options and determine what’s best for your needs.
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Neither New York Life nor its agents provide personal tax advice. Contact your tax professional to find out how the general concepts in this article do or do not apply to your personal circumstances.