Tax treatment is one of the most misunderstood parts of annuities. The tax-deferral feature is often promoted, but the full picture depends on whether your annuity is bought with pre-tax or after-tax dollars, how you take money out, and your age. This guide covers the general rules. Tax law changes and individual situations differ, so confirm details with a qualified tax professional.
Start with the bucket: qualified or non-qualified
- Qualified annuity. Funded with pre-tax money inside a retirement account, such as a traditional IRA. Because you did not pay tax on the contributions, distributions are generally fully taxable as ordinary income.
- Non-qualified annuity. Funded with after-tax money. You get your original principal back without tax, and only the earnings are taxed.
Roth accounts follow Roth rules, which are different.
Tax deferral explained
In both types, earnings inside the annuity are generally not taxed each year. You owe tax when you take money out. That tax deferral is a real feature, but remember that in a qualified account such as an IRA, tax deferral already exists. An annuity inside an IRA does not add extra tax deferral. People who buy one usually do so for other features such as guarantees or income, not for tax reasons.
How withdrawals are taxed
For a non-qualified deferred annuity, withdrawals are generally treated as coming from earnings first, then principal. This is often called last-in, first-out treatment. That means early withdrawals are taxable until the gain has been taken out. For qualified annuities, the whole withdrawal is generally taxable.
How annuitized payments are taxed
When you convert an annuity into a stream of income payments, a portion of each payment may be treated as a return of your original investment and tax-free, while the rest is taxable. This is based on an exclusion ratio for non-qualified contracts. In a qualified annuity, the entire payment is generally taxable.
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Request my Retirement Income ReviewThe early withdrawal tax
Taxable withdrawals before age 59½ may face an additional 10 percent federal tax, with exceptions such as disability or certain structured payments. This is separate from any surrender charge the insurer applies under the contract, so both costs can apply at once.
Required minimum distributions
If an annuity is held in a traditional IRA or other qualified plan, required minimum distributions generally apply once you reach the applicable age, which depends on your birth year. Non-qualified annuities generally do not have the same required distributions, though contracts and beneficiary rules may impose their own timelines.
Death benefits and beneficiaries
When an annuity owner dies, beneficiaries may owe income tax on the gain in a non-qualified annuity. They do not typically get a step-up in basis the way they might with stocks or real estate. Beneficiary options, including spousal continuation and payout timing, vary by contract, so review them carefully.
1035 exchanges
A Section 1035 exchange allows you to move from one annuity or life insurance policy to another annuity without triggering immediate tax if done correctly. This can be useful, but surrender charges and new terms may apply. Do not cash out one contract before completing an exchange.
Common mistakes
- Buying an annuity inside an IRA for tax deferral alone.
- Forgetting that gains are taxed as ordinary income.
- Ignoring surrender charges and the 10 percent additional tax.
- Taking a large withdrawal in a single year without considering tax brackets and Medicare premiums.
- Cashing out instead of exchanging.
Learn the product first
If you are new to annuities, start with our explainers on single-premium annuities and fixed indexed annuities.
Planning around your tax year
Because annuity withdrawals can add to taxable income, timing matters. Taking a large amount in a single year can push you into a higher bracket, increase the portion of Social Security that is taxed, and raise Medicare premiums later. Spreading withdrawals over several years, where the contract allows, can sometimes smooth the tax effect. Your tax professional can model this using your actual numbers, which is something no general article can do for you.
How we help
We are an independent agency. We explain product features from multiple carriers but we do not give tax advice. Your CPA or tax attorney should confirm how any product affects your return.
Availability and rules vary by state
Life insurance and annuity products, rates, riders and consumer protections differ by state, and a given product may not be available in every state. Honorbrook is licensed in the 11 states below; which products we can offer you depends on what carriers sell in your state. Each state’s insurance regulator can verify an agent’s license and answer consumer questions.
- Virginia: Virginia Bureau of Insurance
- Maryland: Maryland Insurance Administration
- North Carolina: North Carolina Department of Insurance
- South Carolina: South Carolina Department of Insurance
- Georgia: Georgia Office of Insurance and Safety Fire Commissioner
- Alabama: Alabama Department of Insurance
- Louisiana: Louisiana Department of Insurance
- Texas: Texas Department of Insurance
- Michigan: Michigan Department of Insurance and Financial Services
- Indiana: Indiana Department of Insurance
- West Virginia: West Virginia Offices of the Insurance Commissioner