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Annuities

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Are Annuities Taxable?

November 8, 2024
5 min
Are annuities taxable

Annuities can provide reliable income streams for retirement, but their tax treatment can be complex and often confusing. In this guide we’ll help you understand how annuities are taxed, when they’re taxed, and strategies to manage your tax liability effectively.

Different types of annuities and their tax treatment

The fundamental rule of annuity taxation is that you pay taxes on the earnings portion of your annuity withdrawals, not on the return of your principal investment. However, how and when these taxes apply depends on several factors, including the type of annuity, how you funded it, and how you receive payments.

Qualified annuities

Qualified annuities are purchased with pre-tax dollars, typically through retirement accounts like traditional IRAs or 401(k)s. These annuities follow specific tax rules:

  • Contributions are typically tax-deductible in the year they’re made
  • All withdrawals are fully taxable as ordinary income
  • Required Minimum Distributions (RMDs) must begin at age 73 (as of 2024)
  • Early withdrawals before age 59½ may incur a 10% tax penalty

For example, if you purchase a qualified annuity with $100,000 from your traditional IRA, every dollar you receive in payments will be taxed as ordinary income, because you never paid taxes on the initial investment.

Non-qualified annuities

Non-qualified annuities are purchased with after-tax dollars. Their tax treatment is more complex:

  • Only the earnings portion is taxable
  • The principal return is tax-free
  • Payments are partially taxable based on the exclusion ratio
  • No RMDs are required

Understanding the exclusion ratio

The exclusion ratio is crucial for non-qualified annuities. It determines how much of each payment is considered taxable earnings versus tax-free return of principal. The formula is:

Investment in Contract ÷ Expected Return = Exclusion Ratio

For example:

  • Investment: $100,000
  • Expected Return: $150,000
  • Exclusion Ratio: 66.7%

This means 66.7% of each payment would be tax-free return of principal, while 33.3% would be taxable earnings.

Lump sum withdrawals

Taking a lump sum from your annuity triggers the “last in, first out” (LIFO) rule:

  • Earnings are withdrawn first and are fully taxable
  • Principal comes last and is tax-free
  • Early withdrawal penalties may apply before age 59½

Example:

If you have an annuity worth $150,000 with a cost basis of $100,000:

  • First $50,000 withdrawn is fully taxable (earnings)
  • Remaining $100,000 is tax-free (principal)

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Regular annuitization payments

When you annuitize your contract:

  • Each payment contains both principal and earnings
  • The exclusion ratio determines the taxable portion
  • Once you exceed your principal, all payments become fully taxable

Partial withdrawals

Partial withdrawals from non-annuitized contracts:

  • Follow the LIFO rule
  • Earnings are taxed first
  • Principal is withdrawn last
  • May trigger surrender charges from the insurance company

Death benefits

When annuity death benefits are paid to beneficiaries:

  • The beneficiary is taxed on the earnings portion
  • The cost basis remains tax-free
  • Different rules may apply for spouse beneficiaries
  • Step-up in basis typically doesn’t apply to annuities

1035 exchanges

The IRS allows tax-free exchanges of annuities under Section 1035:

  • Must be a direct transfer between insurance companies
  • New annuity must be of the same type
  • Can be used to upgrade to better terms or rates
  • Cost basis carries over to the new contract

Tax reporting requirements

Form 1099-R

Insurance companies report annuity distributions on Form 1099-R:

  • Shows total amount distributed
  • Indicates taxable amount
  • Identifies distribution codes
  • Must be included with your tax return

Form 5498

For qualified annuities:

  • Reports contributions
  • Shows fair market value
  • Records required minimum distributions

Timing your withdrawals

Strategic withdrawal timing can help manage tax liability:

  • Consider taking withdrawals in lower-income years
  • Spread withdrawals across tax years
  • Coordinate with other retirement income sources

Structuring your annuity

Consider tax efficiency when setting up your annuity:

  • Joint life annuities can spread tax liability
  • Period certain options may offer tax advantages
  • Ladder multiple annuities for tax flexibility

Using multiple annuity types

Diversifying across annuity types can provide tax advantages:

  • Mix qualified and non-qualified annuities
  • Balance immediate and deferred annuities
  • Consider variable annuities for tax-deferred growth

Early withdrawal penalties

Avoid triggering unnecessary penalties:

  • Understand the 59½ rule
  • Plan for exceptions if needed
  • Consider substantially equal periodic payments (SEPP)

Missing RMD requirements

For qualified annuities:

  • Track RMD deadlines
  • Calculate correct amounts
  • Understand aggregation rules
  • Avoid 25% penalty on missed RMDs

Overlooking state taxes

Remember that state taxation varies:

  • Some states tax annuities differently
  • State tax rates may differ
  • Consider state tax treatment in planning

The takeaway

Understanding annuity taxation is crucial for effective retirement planning. While annuities can provide valuable retirement income, their tax treatment requires careful consideration and planning. Working with qualified tax and financial professionals can help ensure you make the most of your annuity while managing tax implications effectively.

Remember that tax laws change periodically, and individual circumstances vary significantly. Regular review of your annuity strategy with tax professionals can help ensure you’re maximizing tax efficiency while meeting your retirement income needs.

Let Peachtree help

At Peachtree Financial Solutions, we’ve helped thousands of people get their money sooner by purchasing their future annuity payments for a lump sum of cash. Selling your payments is a regulated process and we have a lot of experience with these transactions. And while every annuity is unique, which means every payment sale will be different, they all have the same basic five steps:

  • Call one of our representatives.
  • Receive a free, no-obligation quote for the sale of your payments.
  • Review and sign the purchase agreement.
  • We process the agreement with your insurance company.
  • You get your cash!

Why should you choose Peachtree?

It’s all part of something we call the Peachtree Promise: our experienced, dedicated representatives listen to your goals and clearly explain your available options. We meet you where you are without judgement and work hard to help you meet your financial goals. Getting your quote is completely free, and you’re under no obligation to sell to us if you aren’t completely satisfied with what you hear.

All transactions are at Peachtree’s sole discretion and are subject to court approval and other underwriting requirements. Peachtree does not provide legal, tax or financial advice; please consult with appropriate independent professionals for such advice.

This information is provided for educational and informational purposes only. Such information or materials do not constitute and are not intended to provide legal, accounting, or tax advice and should not be relied on in that respect. We suggest that You consult an attorney, accountant, and/or financial advisor to answer any financial or legal questions. 

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Are Annuities FDIC Insured?

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