How are annuities taxed?
It depends. Certain types of annuities, such as those used to fund structured settlements due to personal injury settlements, are tax free. Most other types of annuities are subject to income tax. However, annuity taxation works differently than the taxation of income that you earn from work. Annuities are tax-deferred: income tax only applies when the annuitant, or the recipient of the annuity payments known as the payee, receives funds from the annuity.
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If you use pre-tax dollars -- funds from an IRA or 401(k), for example -- to buy an annuity, it is called a “qualified annuity.” When payout begins, the normal federal income tax rate applies to each payment in full.
On the other hand, if you use after-tax dollars (money you have saved from your paychecks, for example), the annuity is called a “nonqualified annuity.” Because the funds you used to buy the annuity have already been subject to income tax, you will not pay income tax on the part of the payment that comes from your original investment. However, you will be taxed on the part of the payment that accrues from interest and investment income. Even then, that portion is taxed as ordinary income rather than the capital gains rate.
Tax Rates by Annuity Type
Annuity taxation can vary greatly depending on the kind of annuity. As such, when investors choose a particular annuity, they may consult with a tax professional to understand the tax implications of that type of annuity. Every annuity, however, occurs in two phases.
- Accumulation - During this phase, the annuitant makes payments into the annuity. This can happen in several different ways. Whether the holder makes one large payment, a series of smaller payments or anywhere in between, this phase persists until the annuity begins to pay out.
- Distribution - The distribution or “annuitization” phase occurs when the annuitant begins to receive their payments. Depending on the type of annuity, the payout can take the form of a large lump sum or a periodic payment that the annuitant or designated payee receives over a predetermined term. The payments are taxable income.
Below are some different features that an annuity may have and their possible tax implications.
- Qualified - Qualified annuities are purchased with pre-tax dollars, so payments received are taxed according to an individual’s regular income tax bracket.
- Nonqualified - Since after-tax dollars are used to buy this kind of annuity, the IRS will calculate the tax rate according to several different formulas.
- Deferred - In deferred annuities, the distribution phase is delayed until a specific date. This likewise delays taxes on the annuity, allowing the account to compound interest and grow more rapidly.
- Immediate - True to its name, immediate annuities pay out as soon as they are purchased.
- Fixed - A fixed annuity, allows the purchaser to lock in an exact payout. Your taxable income will be determined based on whether the annuity is qualified or non-qualified. If the annuity is qualified, your life expectancy, principal, and estimated total earnings will be used to calculate what you owe in taxes.
- Longevity - Longevity annuities, although similar to deferred annuities, cannot pay out until the annuitant reaches 80 years of age. This gives the holder some security against the possibility of outliving their retirement money.
- Variable - The value of a variable annuity varies depending on stock market movements and is taxed accordingly.
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The above is just some information on the topics, and is not a complete guide. Peachtree Financial Solutions is a purchaser of assets and does not provide legal, tax, or financial advice. Please contact independent professionals for legal, tax, and/or financial advice.