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Annuities represent one of the most complex financial instruments when it comes to taxation, particularly during the withdrawal phase. Understanding how your annuity withdrawals will be taxed is crucial for effective retirement planning and avoiding unexpected tax burdens. This comprehensive guide examines the various tax implications you’ll face when withdrawing money from different types of annuities.

How annuities are taxed (in a nutshell)

The taxation of annuity withdrawals depends primarily on how the annuity was funded and the type of withdrawals you make. The Internal Revenue Service (IRS) treats annuities as tax-deferred investment vehicles, meaning you don’t pay taxes on the growth while the money remains in the contract, but you will face tax consequences when you begin taking distributions.

The fundamental principle governing annuity taxation is the distinction between your “basis” (the money you contributed with after-tax dollars) and the earnings generated within the contract. Your basis represents money that has already been taxed and can be withdrawn tax-free, while earnings are subject to ordinary income tax rates when distributed.

Non-qualified annuities

Non-qualified annuities are purchased with after-tax dollars, meaning you’ve already paid income tax on the money used to buy the annuity. When you withdraw from a non-qualified annuity, the taxation follows specific rules:

• Last-In-First-Out (LIFO) method: The IRS requires that withdrawals from non-qualified annuities be treated as coming first from earnings, not from your original investment. This means the first dollars you withdraw are considered taxable income, while your original investment (basis) comes out last and is tax-free.
• Exclusion ratio for annuitization: If you choose to annuitize your contract (convert it to a stream of regular payments), each payment consists of both a taxable portion (earnings) and a tax-free portion (return of basis). The exclusion ratio determines what percentage of each payment is tax-free. This ratio is calculated by dividing your total investment by the expected total return over your life expectancy.

Qualified annuities

Qualified annuities are funded with pre-tax dollars, typically through employer-sponsored retirement plans like 401(k)s or through traditional IRAs. Because you received a tax deduction when contributing to these accounts, the entire withdrawal from a qualified annuity is subject to ordinary income tax.

• No basis considerations: Since you never paid income tax on the money used to purchase a qualified annuity, there is no tax-free basis to recover. Every dollar withdrawn is taxable as ordinary income.
• Required minimum distributions: Qualified annuities are subject to required minimum distribution (RMD) rules beginning at age 73. Failure to take required distributions results in a substantial penalty of 25% of the amount that should have been withdrawn.

Withdrawal methods and tax implications

Let’s take a closer look at how the way you withdraw your money affects how it is taxed:

• Partial withdrawals: When you make partial withdrawals from a non-qualified annuity, the LIFO taxation rule applies. This means you’ll pay ordinary income tax on withdrawals until you’ve exhausted all the earnings in your contract. Only after all earnings have been withdrawn will you begin receiving your basis back tax-free.

• Full surrender: When you surrender your entire annuity contract, you’ll receive the full accumulated value. For non-qualified annuities, you’ll pay ordinary income tax on the amount that exceeds your basis. For qualified annuities, the entire distribution is taxable as ordinary income.

• Annuitization: Annuitization converts your annuity into a series of periodic payments, typically for life or a specified period. The tax treatment depends on whether the annuity is qualified or non-qualified:

• Non-qualified annuities: Each payment is partially taxable and partially tax-free, based on the exclusion ratio. This ratio remains constant throughout the payment period, providing predictable tax consequences.
• Qualified annuities: The entire amount of each annuity payment is taxable as ordinary income since no after-tax contributions were made to the contract.

Age-related tax considerations

How old you are will also impact the nature of your annuity taxation.

• Early withdrawal penalties: If you’re under age 59½ when you make withdrawals from an annuity, you may face a 10% early withdrawal penalty in addition to ordinary income taxes. This penalty applies to the taxable portion of your withdrawal and is designed to discourage early access to retirement funds.
• Exceptions to early withdrawal penalties: Several exceptions exist, including withdrawals due to disability, certain medical expenses, higher education costs, first-time home purchases (up to $10,000 lifetime limit), and substantially equal periodic payments under IRS Section 72(t).
• Post-59½ withdrawals: Once you reach age 59½, you can withdraw from your annuity without facing the 10% early withdrawal penalty. However, you’ll still owe ordinary income tax on the taxable portion of your withdrawals.

Tax Rates and planning considerations

A few things you should keep in mind:

• Ordinary income tax treatment: Annuity withdrawals are taxed as ordinary income, not as capital gains. This means they’re subject to your marginal tax rate, which can be significantly higher than long-term capital gains rates. For high-income individuals, this can result in substantial tax liability.

• State tax implications: Most states that impose income tax will also tax annuity withdrawals as ordinary income. However, some states offer more favorable treatment or don’t tax retirement income at all. Understanding your state’s tax laws is crucial for comprehensive tax planning.

• Medicare and social security considerations: Annuity withdrawals count as income for determining Medicare Part B and Part D premiums through the Income-Related Monthly Adjustment Amount (IRMAA). Large withdrawals can push you into higher premium brackets. Additionally, annuity income may cause more of your Social Security benefits to become taxable.

Strategic tax planning for withdrawals

Now let’s go over a few ways you can optimize your withdrawals:

• Timing withdrawals: Consider your overall tax situation when timing annuity withdrawals. Taking larger withdrawals in years when your other income is lower can help minimize your overall tax burden. Conversely, spreading withdrawals over multiple years can help avoid pushing yourself into higher tax brackets.

• Coordinating with other retirement accounts: Develop a comprehensive withdrawal strategy that considers all your retirement accounts. You might withdraw from taxable accounts first, then tax-deferred accounts like traditional IRAs and 401(k)s, and finally from tax-free accounts like Roth IRAs.

• 1035 exchanges: Section 1035 of the tax code allows you to exchange one annuity for another without triggering immediate tax consequences. This can be useful for improving your contract terms or moving to a more suitable product without creating a taxable event.

Death benefits and beneficiary considerations

Let’s go over how an annuity holder’s passing can impact its taxation:

Non-qualified annuities

When you die, your beneficiaries will receive the annuity’s death benefit. They’ll owe ordinary income tax on any amount that exceeds your basis in the contract. The tax treatment depends on how the beneficiary receives the funds:

• Lump Sum: The beneficiary pays tax on the entire taxable amount in the year received.
• Installments: The beneficiary pays tax on the taxable portion of each payment as received.
• Spousal continuation: A surviving spouse can continue the contract as if they were the original owner, maintaining the tax-deferred status.

Qualified annuities

For qualified annuities, beneficiaries must pay ordinary income tax on the entire death benefit since no after-tax contributions were made. The same distribution options generally apply, but specific rules may vary depending on the type of qualified plan.