The way you receive annuity income determines the tax you pay.

When you purchase an annuity, you postpone paying tax on your earnings until you begin receiving income from your contract. Then taxes are due on some or all of each payment at the same rate you pay on your ordinary income. Figuring the amount you owe can be complicated, so it’s wise to consult your tax adviser and review IRS Publications 939 and 575.

Taxes on Annuity income

If you annuitize a nonqualified annuity, part of the income you receive is the return of your cost basis, or premium. The rest comes from your accumulated earnings. The portion that represents a return of your premium is tax free because you paid tax on that money before you bought your annuity. The balance is taxable.

If you receive periodic or systematic payments or make occasional withdrawals from your nonqualified deferred annuity during the accumulation phase, the tax law assumes you don’t begin to get your premium back until you have received all of the earnings. This means all of your income is taxable in the early years of periodic withdrawals.

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If you take a lump sum, you owe tax plus the potential penalty on all of the earnings in the year you make the withdrawal.

With a qualified annuity, the total amount of each income payment you receive is generally taxable because you reduced your salary by the amount of the premium and paid less in taxes at the time you purchased or added to the contract. The same is true of an annuity you own in an IRA if you were entitled to a tax deduction for your contribution.

Taxing fact

 When you estimate the income you need in retirement, don’t forget that you’ll still owe income taxes.

Finding what you owe

Fixed annuities

With a fixed annuity, you divide the premiums paid for the annuity by the expected return, determined by IRS tables. The resulting fraction or percentage is the nontaxable portion of each payment until all of the investment amount has been returned. The balance is taxable.

Premium paid (Cost basis) / Expected return = Nontaxable portion of payments

For example

If you invested $100,000 in an annuity, and the expected total return is $250,000 based on your life expectancy and the interest rate being paid, you’d divide the investment total by the expected return:

$100,000  / 250 000 = 40% Nontaxable portion of payments

That means that 40% of the payments you receive in that year are free of tax, and 60% are taxed at your regular rate. So if you were getting $650 a month, you’d owe tax on $390 of it, or on $4,680 of your $7,800 annual income.

Monthly income $ 650
Percentage taxable x .60
Taxable income = $ 390
x 12

Annual taxable income = $ 4,680

Taxes on guaranted benefit withdrawals

When you choose a guaranteed lifetime withdrawal benefit rider, the income you take each year is taxed differently than the income you receive when you annuitize a nonqualified contract.

With the rider, the IRS considers all the money you withdraw to be taxable earnings as long as the remaining balance in the account is at least equal to your investment in the contract, which is your premium minus withdrawals. In contrast, when you annuitize, a portion of each payment is a nontaxable return of premium until the entire premium has been paid back. However, with the rider you can, if necessary, access the money in your account, something you can’t do if you annuitize.

Taxing Annuity Income

Variable annuities taxation

With a variable annuity, the excluded amount is figured a little differently, since there is no way to predict the expected total return. Here, you divide your cost basis, or the amount you spent on premiums, by the number of years you expect payments to be made. In a fixed-term contract, the number of years is the same as the fixed term. When you arrange for lifetime payment, you use your life expectancy depending on the payout option you choose to determine the number of years.

Cost basis / Number of years portion of of expected payments = Nontaxable portion of annual income

For example

If you had paid in $100,000 and your life expectancy was 20 years at the time you annuitized, the annual income you could exclude from taxes would be $5,000.

$100,000 / 20 =$5000 Nontaxable portion of annual income

In this case, after you collected payments for 20 years, all of your income would become taxable.

Beneficiary taxes

If you’ve started to collect income from your annuity, but die before all of the amount you’re guaranteed has been paid, your beneficiary gets the remaining income. Those payments are free of income tax to the same extent they were free of income tax during your lifetime, and this continues until the value of the cost basis has been fully repaid. The remaining income is fully taxable.

If you die before you annuitize, your beneficiary gets the death benefit provided in the contract. The cost basis is returned tax free, and the balance is taxed in the manner which reflects the way it’s received: lump sum, periodic payments within five years, or annuitization starting within one year after the date of your death. The payout method is determined by the terms of the contract and who the beneficiary is.

Premature distributions 

One of the limitations of tax-deferred investing is that you usually owe a 10% penalty on the taxable portion of withdrawals you make before you reach age 59½. Congress imposes this penalty to discourage you from touching your retirement money before you actually retire. There are some exceptions that let you withdraw from deferred annuities without owing the federal tax penalty, though you do pay income tax on the taxable amount:

  • You can withdraw if you are disabled
  • You can annuitize for your life or joint lifetimes, or set up a series of substantially equal periodic payments to last for your lifetime or the joint lifetimes of you and your spouse
  • In certain circumstances with a qualified annuity contract, you can use a portion of your contract value to pay higher education expenses or buy a first home

The penalty doesn’t apply to immediate annuity payments, which you can begin to receive at any age.

Paying estimated taxes 

While you work, your employer typically withholds enough from your paycheck to cover the income taxes you owe. After you retire, however, it’s your job to figure out — and prepay — the correct amount.

Generally, if you expect to owe at least $1,000, you must make quarterly estimated tax payments. Although annuity companies will withhold taxes from your income payments, you’ll have to coordinate with the company to determine what you owe and to be sure the paperwork is in order.

Taxing Annuity Income by Inna Rosputnia

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