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The tax implications of annuities depend on the type of annuity, how you receive payouts, and whether funds invested are pretax or after-tax.
If you purchase the annuity with pretax funds, your annuity is considered “qualified,” and generally all payouts will be fully taxable since you didn’t pay taxes on your contributions or your investment returns as they accrued. Qualified annuities are usually funded from an IRA, 401(k) or another tax-deferred account. If you use after-tax dollars, your annuity is “non-qualified,” and you’ll generally pay taxes only on the part of your payouts that represent investment earnings because you’ve already paid taxes on the principal. Either way, annuity distributions are typically not taxed at the lower capital gains tax rate.
If you invest after-tax money and your annuity pays out for the rest of your life, the Internal Revenue Service (IRS) will generally use your age to calculate your tax burden.
For example, if Steve invests $100,000 in an immediate annuity today and his age is 65, the IRS, under current codes, would likely consider $5,000 of Steve’s payments to be tax-free every year because it would represent the return of his original investment to him. Distributions over the $5,000 threshold would likely be taxable for the given year. In this example, if Steve were to live longer than 25 years, all distributions he would receive after that would most likely be fully taxable.
For deferred annuities, the same general rules apply about which portions of payouts are taxable, but some of the implications are different because the payouts have been deferred. While immediate annuities are calculated using your age at the annuity starting date, deferred annuities also take into account the starting date of the annuity.
If you receive all of your annuity proceeds in one lump sum, you’ll most likely pay income taxes on the investment gains only. However, if you make several smaller withdrawals, the IRS may consider your first withdrawals to come from earnings, which will be fully taxable. For example, if your original $100,000 investment grew to be $150,000, and you scheduled three withdrawals of equal amounts, the first $50,000 withdrawal would likely be fully taxed as earnings, and the second and third would not be subject to income taxes since those funds were invested after you already paid taxes on them.
Annuity taxes can be very complicated, so always consult your tax advisor before you consider purchasing an annuity.
Information was sourced from IRS Pub. 575 and is current as of May 21, 2019. This information is subject to change.