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How Do Annuity Taxes Work?

Question 4 In The Should I Buy An Annuity Series


Taxes on Annuities

Before you buy, learn how future annuity income will be taxed.

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Taxes should be considered as part of your decision making process. Many times tax-deferral is used as a selling point for variable annuities, but unless you are in a very high tax bracket and have a long time frame before you need income, it may not actually be of much benefit to you. Here's a quick overview of how different types of annuities are taxed.

Taxes and Deferred Annuities (Fixed or Variable)

When you purchase a deferred annuity, whether fixed or variable, the amount you invest is your cost basis. From that point any investment gains (or losses) are tax deferred. That means you will not receive a 1099 on the interest, dividends or investment gains that are earned each year so they do not have to be reported on your tax return. Tax deferred, however, is not the same as tax free.

At such time as you take a withdrawal from a deferred annuity, gain is considered to be withdrawn first, and all withdrawals are taxed at your ordinary income tax rate. Any withdrawals prior to age 59 ½ are also subject to a 10% penalty tax.

Taxes and Immediate Annuities

With an immediate annuity, a portion of each payment you receive is considered a return of principal (a return of your own money) and a portion is interest. You will pay tax on the portion that is interest but not on the portion that is considered a return of principal. The insurance company will provide you a tax statement that designates which portion is taxable.

Before you buy the annuity the insurance company can also tell you what your exclusion ratio would be. The exclusion ratio is the amount of each monthly payment that can be excluded from taxes.

If you convert a deferred annuity into an immediate annuity, the annuity tax will function like an immediate annuity, with a portion of each payment considered a return of principal and a portion as interest.

Next Question 5: What Happens To The Annuity Upon My Death?

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