How Are Annuities Taxed?

Annuities provide you with income for the rest of your life or your general life expectancy. They are attractive because they offer tax-free growth until you withdraw the funds. You can also re-invest any money you earn in interest or dividends, allowing it to grow tax-free as well. Eventually, though some or all of your annuities are taxed.

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Keep reading to learn more about annuities and taxes.

Qualified and Non-QualifiedAnnuities

One of the largest distinctions you must make about your annuities is if they are qualified or non-qualified.

If you used money that you didn’t pay taxes on to buy the annuity, it’s qualified. An example is an annuity that you purchase with 401K funds. You didn’t pay taxes on your 401K funds since you contribute pretax income to your 401K. Any payments you receive from the annuity in the future will be taxed as regular income.

If you use money that you already paid taxes on, such as a Roth IRA, you buy a non-qualified annuity. You won’t pay taxes on this money again – this is the principal balance. You will pay taxes on any interest or dividends that you earn, though.

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How Will you Receive Payments

Another consideration in annuity taxation is how you will receive payments. The most common are period and lifetime annuities.

Period annuities provide you with a pre-determined amount of income for a set number of years. Say you have a 15-year annuity that will pay $10,000 per year. Your total annuity would be worth $150,000. This is the amount the IRS expects you to earn.

Lifetime annuities pay you monthly for the rest of your life. In order to determine your return, you’ll need your estimated life expectancy. You then multiply your life expectancy by the amount the annuity will pay each year to determine your expected return.

Here’s an example:

Let’s say you bought a $100,000 lifetime annuity. Your expected return is $175,000. Divide $100,000 by $175,000 and you get 57%. This means that 57% of each payment that you receive will not be subjected to taxes, but the remaining 43% will.

Consult your tax advisor before choosing an annuity to see how it would affect your taxes. If the annuity income will put you over your tax bracket, you may want to look at other options. Your tax advisor can help you decide what’s right for you.

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