How are annuities taxed? 3 things you need to know

Annuities are popular with retirement investors because they can offer an income stream during the golden years. While this feature may make annuities attractive to retirees, they also should not overlook the tax advantages of annuities that help make that cash flow possible.

Here are the tax advantages offered by annuities – and three key things to know about them.

3 key tax advantages of annuities

Annuities can offer various tax benefits that make them attractive for savers.

1. Your earnings are tax-deferred in the accumulation phase

If you choose a deferred annuity, you’ll add money to the annuity over time, and that money will compound at whatever rate you’ve contractually agreed to during the “accumulation phase.” (So look at the best annuity companies.) Those earnings are tax-deferred so long as they’re inside the annuity, letting you earn compound interest and to amass a larger nest egg for retirement.

If you opt for an immediate annuity, you’ll deposit your money in a lump sum and won’t enjoy this tax-deferred benefit during the accumulation phase. Immediate annuities begin paying out in less than a year, so you’ll need to have amassed your money before you make your deposit.

The tax-deferred feature of annuities makes them especially attractive for higher-earners, letting them delay taxes on their earnings and pay less taxes while still growing their wealth.

2. Your payouts may be taxable – or they may not be

The taxability of your annuity’s payouts during the distribution phase – also known as the annuitization phase – depends heavily on whether your contributions were made with pre-tax money (known as a qualified annuity) or after-tax money (known as an nonqualified annuity).

• Qualified annuities: Annuity contributions made with pre-tax money such as in a traditional IRA or traditional 401(k) or 403(b) plan, are taxable when they’re distributed from the account. Any earnings distributed from this type of plan also become taxable at this point. Taxes are paid at ordinary income rates on withdrawals in retirement.
• Non-qualified annuities: Annuity contributions made with after-tax money are not taxable when distributed. In this type of annuity only the earnings are taxable during the distribution phase. Earnings are taxed at ordinary income rates, and you may be hit with the net investment income tax of 3.8 percent, if you exceed the annual thresholds for that tax.

Depending on the type of annuity, your payout may consist of all earnings or a combination of earnings and contributions. The exact combination will affect your taxes if you have a nonqualified (i.e., after-tax) annuity, since contributions to this type of account are not taxable when paid out. In other words, you may end up paying taxes on only a portion of your payout.

The annuity company will report the exact taxable amounts to you annually on Form 1099-R.

3. You can exchange annuities tax-free

Annuity owners can switch annuities tax-free to another annuity of a like kind using what’s called a 1035 exchange. If they use a 1035 exchange, annuity owners must switch one annuity for a similar kind, the funds must be moved directly between annuity providers and the annuitant or owner must remain the same, in order to maintain the tax-free treatment.

While a transfer can be made tax-free, annuity owners will want to carefully assess whether it makes sense for them to do so. The annuity company may levy various fees and charges, and surrender fees on a new annuity may limit accessibility or make it costly to access your money.

Taxes on annuities in an IRA or 401(k) account

Whether you hold your annuity inside a tax-advantaged retirement plan such as a 401(k) or IRA – and whether it’s a Roth account – can also affect how an annuity’s distributions are taxed:

• As mentioned, the distributions from annuities in a pre-tax 401(k), pre-tax 403(b) or pre-tax IRA are fully taxable, as any distribution from these pre-tax accounts would be.
• Distributions from an annuity held in a Roth 401(k), Roth 403(b) or Roth IRA are not taxable, whether they’re contributions or earnings.

Many financial advisors suggest that investments such as stock funds should be used in Roth accounts because they have the potential to offer much higher tax-free returns than annuities do.

Taxes and penalties on annuity withdrawals

If you withdraw money from your annuity before age 59 ½, you’ll likely get hit with taxes and penalties. The exact mounts depend on the type of annuity:

• Early withdrawals from a pre-tax (qualified) annuity will likely result in taxes being assessed at ordinary income rates on the contributions and earnings. In addition, the IRS will also assess a 10 percent penalty on the withdrawn amount.
• Early withdrawals from an after-tax (non-qualified) annuity will likely result in taxes being assessed on only earnings withdrawn from the account. In addition, the IRS will also assess an additional 10 percent penalty on the withdrawn earnings.

Some exceptions to these rules exist, such as if the policy holder becomes disabled.

Bottom line

It’s vital to understand the tax advantages of annuities and how they can help you amass a nest egg for a successful retirement. But annuities can be complex, and it can be worthwhile to speak with a financial advisor working as a fiduciary (i.e., in your best interest) so that you receive unbiased advice. This financial advisor matching tool matches clients with advisors in minutes.