By Amanda Gile
Deferred annuities are contracts with insurance companies where you make one or more contributions, and in return, they invest the funds and send you payouts later. These annuities usually have longer terms, often lasting several years, allowing your contribution (or principal) to grow over time.
When you start receiving payouts, you'll need to plan for taxes. Understanding the taxation of deferred annuities — including tax-deferred variable annuities and fixed annuities — is essential for successful financial planning. Keep reading to learn how the IRS taxes annuities so you can pick the best contract for your needs.
The IRS taxes deferred annuities based on whether they’re qualified or non-qualified, which we’ll break down below.
Qualified annuities are funded with pre-tax dollars, usually through retirement accounts like a 401(k) or IRA. Because you contribute before taxes, the IRS taxes all withdrawals — both the principal and earnings — as ordinary income during the year you receive them.
Individuals with qualified annuities must start taking required minimum distributions (RMDs) at age 73, or they’ll face steep penalties. Withdrawing before age 59½ can also result in a 10% early withdrawal penalty, plus ordinary income taxes, so timing is critical in tax planning.
Funding for non-qualified annuities comes from after-tax dollars, so taxes have already been paid on the principal funds. When a person starts taking distributions, they’ll only owe taxes on any interest earned on top of the initial contribution.
The IRS uses the exclusion ratio to determine how much of each annuity payment is taxable. To calculate it, divide the total principal by the expected return. This ratio shows which portion of each payment is considered non-taxable.
For example, if you contribute $100,000 and the expected return is $200,000, the exclusion ratio is 50%. That means half of each annuity payment is tax free, and the other half — which represents earnings — is taxed as ordinary income.
Another benefit of non-qualified annuities is that they aren’t subject to required minimum distributions (“RMDs”), giving you more flexibility in withdrawal timing. However, withdrawals before age 59½ may still trigger a 10% penalty on the taxable portion, depending on the type of annuity you choose.
There are two primary methods of accessing your deferred annuity funds: Annuitization and lump-sum or discretionary withdrawals. Each has distinct implications regarding tax treatment.
When you annuitize a deferred annuity, you turn its value into regular income payments. These distributions can last for a set number of years, your lifetime, or the lifetimes of you and a beneficiary.
Annuitized payments often provide predictable income, which can simplify tax planning and estimated tax payments. They're taxed differently depending on whether the annuity is qualified or non-qualified.
Taking a lump sum withdrawal means you’ll get the entire amount, principal and interest, in a single payment. This can result in significant tax bills, especially for large accounts, and may require careful planning to avoid excess expenses.
As with any annuity, the account’s qualified or non-qualified status will affect the taxable income:
Discretionary withdrawals, otherwise known as “free withdrawal provisions,” are non-scheduled funds the owner takes out from the account before annuitization starts. Many insurance companies allow you to take 10% per year without incurring fees. However, depending on your age and contract terms, you may be subject to taxes and penalties.
When you inherit a deferred annuity, the tax treatment depends on the annuity type and your relationship to the original owner.
When a beneficiary inherits a qualified annuity, the entire value is generally taxable as ordinary income.
If the qualified annuity is held within a retirement account, such as a 401(k) or IRA, it may be subject to additional rules. Applicable regulations depend on the beneficiary’s relationship to the original owner:
Failure to follow these rules can cause penalties, and beneficiaries may need to pay estimated taxes on large distributions to avoid underpayment issues.
Similar to the original owner’s tax treatment, non-qualified annuities are taxed only on the earnings portion. Beneficiaries can elect to receive payments over time or take a lump sum.
Some accounts are subject to the five-year rule, which requires beneficiaries to withdraw all funds within five years of the original owner’s death. They can choose to receive distributions or take a lump sum at any time before the five-year period is over.
The choice of distribution method can significantly affect the timing and amount of taxes owed. For instance, taking a lump-sum distribution means you’ll owe taxes on all accumulated earnings in one year. Spreading the distributions over time can mitigate this effect.
Yes — fixed annuities are tax deferred. You won’t owe taxes until you start taking distributions. The amount you’ll owe varies depending on whether the account is qualified or non-qualified.
Tax-deferred annuities have two main disadvantages:
This communication / article is for informational / educational purposes only.
It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. Gainbridge® and its representatives do not offer tax or legal advice. For advice concerning your own situation, please consult with your appropriate professional advisor.
The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes.
SteadyPace™ is issued by Gainbridge Life Insurance Company, Zionsville, Indiana. All guarantees based on the financial strength and claims paying ability of the issuing insurance company.
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