How are annuities taxed?

how are annuities taxedHow are annuities taxed?

Disclaimer: I am not a tax adviser. Please consult with your tax adviser before investing or making any changes. This post is for educational purposes only.

Keep It Simple Answer: Annuities are tax deferred until you withdraw money. Withdrawals are taxed at ordinary income tax rates when you withdraw the money.

So let’s look at a couple examples of how annuities are taxed.

Deposit non-qualified (regular money) into an annuity

  • The annuity will grow tax deferred, meaning you are not paying taxes on the interest every year. Only when you withdraw do you pay taxes.
  • When you withdraw money, all interest comes out first, and it will be taxed at your ordinary income tax rates
  • If you are under 59 1/2 when you withdraw money from an annuity, you may also be subject to a 10% IRA penalty calculated off the interest

Deposit IRA, 401k, 403b, SEP (qualified money) into an annuity

  • It will be taxed the same way as any other investment you have in your IRA, 401k.
  • You have not paid taxes on this money yet, so all withdrawals will be taxed at ordinary income tax rates
  • The same under 59 1/2 penalty applies
  • At age 70 1/2 you will be required by the IRS to start taking your Required Minimum Distributions. These are taxed at ordinary income tax rates too.

A Roth IRA annuity

  • Since you already paid the taxes up front, or on the conversion, withdrawals from a Roth IRA are tax-free
  • This also applies to lifetime income riders. You get tax free income for life

Immediate Annuities

This one is interesting. You deposit money and get an income stream in return.

Part of the income is interest, and part is principal.

So there is something called an exclusion ratio which means. the part of your annuity income that is excluded from taxes because it’s a return of principal.

For example. Let’s say the monthly payment is $1,000 and you have an 80% exclusion ratio. that means that 80% of the monthly income is considered a return of premium and 20% is considered interest.

You only pay ordinary income taxes on the 20%.

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