Taxes on Annuities – What You Need to Know

January 2nd, 2013 by

taxes on annuitiesWhile you must always look beyond the verbiage and read the fine print, avoiding taxes legally is something everyone can appreciate.  One of the most attractive features of an annuity is tax-deferred growth, meaning as long as the money stays in your annuity account, you will not have to pay taxes on the earnings.

It is important to understand however that tax-deferred does not mean tax exempt!

You will eventually have to pay taxes on your annuity, however the amount and schedule depend on the type of annuity ,as well as some other key factors.  As many people have less income in their retirement years, when they do start to receive money from their annuity they may be  in a lower tax bracket than during their working years when they made the contributions.

Before we get into specifics, we should also state that there is 10% tax penalty on distributions (payouts) from an annuity when the payment is made before annuity holder is 59 ½.  You can learn more about early withdrawal penalties here.

Tax Differences Between  Deferred And Immediate Annuities

A deferred annuity grows untaxed during the time in which you are paying into it.  Once you are ready to receive payments, you have the option of taking it as one large sum, however most people elect to receive a series of scheduled payments that occur over a specific period of time instead.  This process is commonly referred to as “annuitization”, and  converts your Deferred Annuity into an Immediate Annuity. When properly handled, this conversion is not a taxable event.

Deferred Annuity Taxes

Taxes are paid only on the profits potion of the lump sum. You do not pay taxes on the dollar amount  that you paid into the  the annuity.  This profit is considered ordinary income, and is taxed based on the specific income tax rates effective in the year of distribution.

Immediate Annuity Taxes

Taxes on an Immediate Annuity work differently, as part of each payment is considered the return of a previously taxed principal (your initial investment), while the other part is considered earnings.  While you will not pay taxes on the portion of the payment which is considered the return of your initial investment, you will pay taxes on the part which is considered earnings.

Figuring Out Taxes on Variable or Indexed, Immediate Annuities

Paying taxes on immediate annuities is calculated a little differently.  With a variable or Indexed annuity, it is impossible to know what the annuity payment will be each month, as the market value of your account will fluctuate depending on your investment choices and market conditions.  In order to determine the taxable amount, your investment is divided by the distribution period you expect to receive annuity payments.  For example, assume your initial investment was $50,000, and the annuity is to make a payment for 10 years.  The investment ($50,000), divided by the distribution term (120 months), comes to roughly $417 per month.  This is the amount that cannot be taxed, any earnings beyond this would be declared and taxed as income for that year.

Figuring Out Taxes on Fixed, Immediate Annuities

You figure out taxes for a fixed immediate annuity the same way that you would for a variable Immediate annuity. The difference is the taxable and non-taxable amount of the payment will be consistent, as your distribution remains consistent month to month.

This lesson is part of our Free Guide to Investing in Annuities.  Continue to the next lesson here.
  Want to learn how to generate more income from your portfolio so you can live better?  Get our free guide to income investing here.

Print Friendly
Please Share!