How Will My Immediate Annuity Be Taxed?
- If you purchased an immediate annuity with pre-tax savings, the income payments you receive will be taxed as ordinary income
- If you purchased an immediate annuity with post-tax savings, only a specific portion of the income payments you receive are taxed
An immediate annuity can be purchased with pre-tax money (qualified annuities) or post-tax money (non-qualified annuities). However, qualified and non-qualified annuities have different tax treatment, which affects the income payments you receive.
Qualified annuities are easy — since the money used to purchase the annuity has never been taxed, all the income that it generates in retirement will be taxed at ordinary income tax rates.
Non-qualified annuities are a little more complicated. Because your annuity was purchased with money that has already been taxed, only a portion of your retirement income will be subject to taxation. Each income payment can be split into two pieces: a part that’s returning your initial premium, and a part that the insurance company determines is your projected gain or interest earned. Taxes will only be owed on the gain, as the premium you invested in the contract has already been taxed. This non-taxable portion of the income payment is determined using an exclusion ratio (the premium you paid/your expected return), which is provided by the insurance company at purchase and is subject to IRS rules.
The exclusion ratio 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.
To see how this works, let’s analyze Matthew’s immediate annuity. If Matthew does not wind up using pre-tax retirement savings to buy the immediate, it’ll be classified as non-qualified.
Immediate annuity rates based on a $174,132 Integrity life-only policy for a male aged-65 with income starting immediately. Rates as of 10/4/2017.
The exclusion ratio for Matthew’s policy is 74%. The insurance company calculated this as the ratio between his investment in the contract ($174,000) and the total amount of income they expect to pay him ($237,000 in this case). Thus 74% of his income payments will be excluded from his taxable income until a total of $178,000 has been excluded. For Matthew, this will be the case once he’s received 20 years worth of payments, after which the income from the immediate annuity will be fully taxable at ordinary income rates.
There’s one last bit! When you purchase an immediate annuity, you have the option to add a beneficiary. This means that your beneficiary will receive the difference in premium paid and income received, if there’s any remaining. If your beneficiary chooses to annuitize that remaining premium (instead of receiving it all at once), that income will be taxed at the regular income tax rate. This doesn’t apply if the payout is coming from a non-qualified annuity where the money was already taxed.
Disclaimer: This article is provided for informational purposes only and not for the purpose of sales, solicitation or inducement to purchase any annuity product. Blueprint Income is not responsible for the accuracy of this information. If you wish to confirm the information contained herein, prior to making an annuity purchase, please consult with your tax advisor.