Understanding How Annuities are Taxed

One significant advantage of purchasing an annuity to fund your retirement plans is that annuities grow tax-deferred. That means earnings won’t be taxed until you make a withdrawal. The advantage of this is that your earnings stay in the account and are re-invested, giving your annuity an opportunity to grow.

 However, annuities are a multi-use financial tool, so there are additional factors to think through when you consider how an annuity may be taxed.

Annuities can be purchased with after-tax dollars or through a tax-advantaged plan like an IRA or 401(k). In this article, you’ll find information on how after-tax contributions to annuities are handled.  

Taxing Premiums

When you use after-tax dollars to fund an annuity (as premiums), you won’t be able to deduct those amounts on your taxes. So, purchasing an annuity doesn’t provide you with immediate tax benefits like some other retirement savings vehicles do. For short-term tax relief, consider putting money into a traditional IRA, 401(k) plan or other retirement plans offered through your employer.

Tax-Deferred Growth

In contrast to many other investments, the interest earned with an annuity is not taxed as it accrues. Annuity funds typically grow on a tax-deferred basis until you withdraw them. Then, you’ll need to pay ordinary income taxes on all gains.

Taxation of Premature Withdrawals

The point in time when you withdraw money from your annuity can greatly impact their cost. If you withdraw funds before you reach age 59 1/2, you may be subject to a 10% IRS penalty, unless you qualify for an exception, such as having a disability,  or terminal illness.

When you withdraw funds from an annuity, the IRS treats the withdrawal as if it is coming from the annuity earnings first, meaning you will pay taxes on the highest percentage of your withdrawal as is possible (either the whole withdrawal or all the earnings that the annuity has made). That means early withdrawals are costly from a tax standpoint.

For example, if your annuity has gained $1,000 in interest and you withdraw $500, the IRS would treat the entire withdrawal as taxable earnings. You would have to pay a $50 early withdrawal penalty as well as the ordinary income tax on the $500 withdrawal. If your tax rate is 25%, you would owe an additional $125 in taxes. Thus, you would have to pay $175 out of your $500 withdrawal to the IRS.

Taxation of Scheduled Distributions

When purchasing your annuity, you can select an annuitization option that will provide you with regular distributions over a set timeframe. Each distribution is made of two parts: the return of your original investment (principal) and any accrued earnings. 

The ratio of principal to earnings in each distribution depends on the annuitization option you selected. The earnings portion is taxable as ordinary income. 

Taxation of Lump-Sum Distributions

Electing to take a lump-sum distribution from your annuity may help you meet your financial goals but can have tax consequences depending on the situation.

Each annuity has a period of time in which you cannot withdraw money without incurring a penalty. If you are within that surrender period, you may incur surrender fees. 

The earnings part of the payout will be taxed as ordinary income in the year you received it, but be aware that taking a substantial lump-sum withdrawal could push you into a higher tax bracket, increasing your overall tax burden.

Make the Wisest Decision for You

As you continue to work toward achieving your financial goals, annuities may be the good option for you. Contact a Farm Bureau agent or financial advisor today to find out what we have to offer.