You may be considering an annuity because it can provide guaranteed lifetime income in retirement. But another benefit of annuities is their tax deferral — you don’t pay taxes on the money in the annuity until you receive the payouts. And a portion of each payout may not be taxable if you used any after-tax money to buy the annuity. The way the taxes are calculated depends on the type of annuity, how you receive the payouts, and whether or not you purchased the annuity with money in a retirement account. No matter what kind of annuity you have, any taxable payouts are subject to income-tax rates rather than capital-gains rates.
If you buy an annuity that pays out a lifetime income stream — whether the payouts start right away (immediate annuities) or start several years in the future (deferred-income annuities) — you won’t be taxed on the money until you start to receive the payouts. The specific tax rules depend on where the money you invested in the annuity came from:
— If the annuity was purchased with money in a Roth IRA, then the payouts are tax-free.
— If the annuity was purchased with money in a traditional IRA and all of your IRA money was from contributions that have not been taxed (whether from tax-deductible contributions to the IRA or rolled over from a 401(k) or other employer’s plan that was funded entirely from pre-tax contributions), then all of your payouts will be taxable.
— If some of the money in the IRA was from non-deductible contributions, then a portion of each payout will be considered a return of principal and will not be taxable and the remainder of each payout will be subject to income taxes.
— If the annuity was purchased with money from a taxable account, then part of each payout is considered to be a tax-free return of principal (since that money has already been taxed), and part of each payout is considered to be taxable earnings.
To calculate the portion of each payout that is a tax-free return of principal, the after-tax money you invested is returned in equal tax-free installments over the annuity’s payment period. If you have a life annuity with payouts that will stop when you die, for example, then the payment period is the IRS’s life-expectancy figure for your age when the payouts begin.
Your insurance company will provide you with the “exclusion ratio” to determine what portion of each payout is a tax-free return of principal and what portion will be taxable. The annuity company usually reports the taxable amount of your payouts each year on Form 1099-R. If you live beyond your life expectancy, then your payouts after that point will be fully taxable — the total you receive as a tax-free return of principal through the years can’t be more than the amount you invested in the annuity.
Some of the tax rules are different if you invest in a deferred annuity that you can cash out or take withdrawals whenever you’d like — such as a deferred fixed annuity or a variable annuity that lets you invest the money in mutual fund-like accounts — rather than receiving a set stream of income payouts that you can’t change. However, these annuities also have the benefit of tax deferral — the money can grow tax-deferred through the years and you can switch the investments within the account without a tax bill, as long as you don’t withdraw money from the annuity.
When you do start to take withdrawals, the tax rules are generally the same as they are for income annuities if you used IRA money: If you invested money from a Roth IRA into a deferred annuity, the payouts will still be tax-free. If you invested money from a traditional IRA that was all from pre-tax or tax-deductible contributions, then the entire payouts are subject to income taxes. You may also have to pay a 10% early-withdrawal penalty if you take the money before age 59 ½.
If you invest money from a taxable account into a deferred annuity, you’ll receive the principal back tax-free but will have to pay income taxes on the earnings. If you cash in the annuity in a lump sum, you’ll be taxed on any amount you receive above the amount you originally invested.
But if you take several withdrawals, then the calculation is very different: Your first withdrawals are considered to be from earnings and income and are entirely taxable. Only after you have received all of the earnings then the remainder of your withdrawals are considered to be a tax-free return of principal. For example, if you invested $100,000 in a variable annuity and your investments increase to $150,000, then the first $50,000 you withdraw will be fully taxable and the last $100,000 will be a tax-free return of principal.
However, if you have a deferred annuity and “annuitize” your payouts — convert them into a lifetime income stream instead of being able to tap the principal again — then your payouts will have the same tax treatment as income annuities, which means that a portion of each payout will be a tax-free return of principal and a portion of each payout will be considered taxable income.
No matter what kind of annuity you have, the tax rules can be complicated. It’s important to work with your annuity company and your tax advisor to find out exactly how much of your payouts are taxable each year.
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