How Annuities are Taxed

As a tax-deferred vehicle under the Internal Revenue Code, annuities as a family of investments are attractive to investors as they allow you to accumulate assets and pay no taxes on the gains of those investments until you actually make a withdrawal on that account. An annuity is a financial contract that promises to make payments to the investor, for a specific period of time, and is often sold or backed by an insurance company.

Since, annuities allow the investor’s money to increase without being taxed every year for the growth in the investment, such contracts act like certificate of deposits that guarantee a predictable rate of return over a particular time – without having to take out a 1099 every year. The question of taxation generally depends on the type of annuity it is and how you purchased it. Because payments for annuity accounts are often made during the accumulation phase in after tax dollars, the investor pays no taxes on the principal investment, but only the earnings.

On the other hand, if you purchase your annuity with money in your IRA with pre-tax funds, then all of the money you get during the distribution phase will be taxed at full rate as those earnings have never been taxed. Another feature that may offer flexibility to the investor is that annuities allow you to transfer money from one variable annuity investment to another, without being taxed or penalized. Only, at the time the money withdrawn from your account is when you actually pay an income tax at your standard tax rate, and not the capital gains rate. If you have money distributed to you before your retirement or before you turn 59.5 years of age, you will also have to pay a standard penalty fee of 10%.

The calculation for annual taxation depends on how the investor withdraws his funds. For illustration purposes, let’s say the investor elects to withdraw all of his money in one lump sum, and the payments he made were purchased with “after tax” dollars. If he invested $10,000 and the account is now with $16,000 – the investor will only pay taxes on the $6000 or the gain in the value the annuity. He keeps the original $10,000 and skips double-taxation. However, if the investor made in his annuity purchase payments with pre-tax dollars, then he will have to pay taxes on the entire $16,000. This may happen when an investor purchases an IRA with pre-tax funds and then elects to purchase annuities with those funds or extra funds. Keep in mind, however, that if an investor withdraws a lump sum payment from his account of say, $500,000, he would be subject to a different tax bracket for that year.

Further, if the investor decides to “annuitize” payments from the annuity account, he will be subject to paying taxes on the earnings of his investment based on his yearly tax bracket – which would be different if he took a significant one lump sum payment. A bit more complex then the lump sum payout, the amount of money taken out in an annuitized manner is taxed by calculated by generating an “exclusion ratio.” This exclusion ratio is figured out by taking the amount of the investment, and dividing it by the amount that is expected to be earned during the distribution period – say monthly or per year.

In addition, if you have a variable annuity, these accounts may be taxed a bit differently since the market changes from month to month, but the calculation is also determined to figure out the exclusion ratio. To ensure proper taxation with regards to your specific taxation scenario you should consult your tax preparer.