Annuity Taxation

Tax-deferred growth allows the money inside a fixed annuity to accumulate earnings without generating annual tax bills. This can be especially beneficial for those looking to save long-term who do not need immediate access to their funds. Because taxes are deferred, earnings remain invested and continue compounding over time.

However, tax-deferred does not mean tax-free. Taxes are generally owed when money is withdrawn from the annuity, and earnings are typically taxed as ordinary income.

If the fixed annuity is purchased with qualified funds (pre-tax income, usually in the form of a contribution to a retirement plan), then a fixed annuity doesn't provide any additional tax benefits beyond what the retirement fund offers, which is tax-deferral of gains until money is withdrawn. Qualified-funded annuities may also be subject to required minimum distributions (RMDs) starting at age 73.

If the fixed annuity is being purchased with non-qualified funds (post-tax dollars, money that has already been received through income sources and income tax has been paid), let's dig deeper into the tax treatment at each phase of the contract:

Taxes During the Term

There are no taxes due during the contract term. Your money isn't subject to taxation while it's growing. Not paying taxes means that you're able to keep more money invested and earning interest. And this benefit continues as long as you keep your money in the contract, which can be beyond the end of the initial guaranteed interest rate term.

Taxes on Withdrawals

Instead, you pay taxes once money is withdrawn, be that during, at the end of, or after the initial interest rate term of the contract. Only the interest gain portion of your withdrawal will be taxable at ordinary income rates. This differs again from when a fixed annuity is purchased with qualified funds, in which case, all withdrawals will be taxable. Waiting until you're in retirement, or in a lower tax bracket, to withdraw can reduce the taxes you owe. Note that you may be subject to a 10% penalty if you withdraw money before age 59½, or surrender charges if you withdraw more money than allowed prior to the end of the investment term.

Rolling Over with a 1035 Exchange

You can continue your tax-deferral by staying with your annuity, or by rolling over your fixed annuity into a new annuity. You can choose to roll it over into another fixed annuity or a different type of annuity through a tax-free 1035 exchange.

It's important to understand the tax implications of fixed annuities and work with a tax professional to develop a plan that helps to minimize your tax burden.

From the government's perspective, an annuity is a retirement savings vehicle. As such, it receives the same tax treatment as IRAs: no taxes are paid until distributions are made. The benefits are slightly different depending on whether the income annuity is funded with qualified or non-qualified funds:

The RMD is an IRS-mandated minimum amount you must withdraw from your tax-deferred retirement accounts every year starting at age 73. However, QLACs are exempt from this rule, allowing you to delay distributions until as late as age 85. By moving money out of your 401(k) or IRA and into a QLAC, you can reduce the required withdrawals and associated taxes between ages 73 and 85, allowing more of your money to work for you on a tax-deferred basis.

The exclusion ratio (investment in the contract ÷ expected return) will be applied to each income payment, indicating how much is not taxable, until the full investment in the contract has paid out. Once the investment has been fully returned, subsequent income payments will be fully taxable.

Finally, if a death benefit or refund at death is due to your beneficiaries, taxes owed will be calculated in a similar manner. Any portion of the death benefit that constitutes a return of premium will be received tax-free, whereas benefits in excess of the initial investment will be taxed at ordinary income levels. Either way, the benefit will be passed directly to beneficiaries, thus avoiding the probate process. And, unless your spouse is designated as your beneficiary, the annuity will typically be included in your estate.

It's important to understand the tax implications of income annuities and work with a tax professional to develop a plan that helps to minimize your tax burden.