How is annuity income taxed? It depends

This article will ... Provide the basics of annuities that underlie how they are taxed. Note that distributions from an annuity in a qualified retirement plan are taxed the same way as money from other investments in the plan. Discuss what the exclusion ratio is and how it plays a part in the taxation of distributions from nonqualified annuities.

Annuities can be very useful retirement tools, as they can provide a guaranteed stream of income for a set number of years or even a lifetime. But how is that income stream taxed?

The answer to the question will affect how much money comes in each individual payment from an annuity and depends on how well-diversified your retirement income is from a tax perspective.

“Tax diversification is very important,” said Victoria Thomas, a financial professional and vice president with Goldbook Financial in Scottsdale, Arizona. “When you have retirement income spread across many buckets — after-tax, pretax, tax-sheltered — it lets you adjust for taxes pretty effectively. Annuities can play a big part in that diversification.”

Pretax or after-tax investment money?

A big part of the answer about how annuities are taxed depends on whether the money used to fund the annuity was already taxed or not.

If the annuity is part of a qualified retirement plan — like a 401(k) plan or traditional individual retirement account (IRA) — then it is generally funded with pretax income. As a result, distributions from the annuity will be taxed like ordinary income.

Thanks to recent legislative changes, there are an increasing number of employer qualified retirement plans (e.g., 401(k), 403(b), 457(b)) that are offering annuities as a plan investment option.

But there are no special tax rules that apply to annuities held within these types of qualified employer plans (or IRAs for that matter). Distributions coming from an annuity investment are taxed the same as any other distribution from the plan — generally fully taxable as ordinary income unless the distributions are attributable to after-tax contributions made to the plan.

If the annuity is nonqualified — that is, funded with after-tax money and not part of an IRA or employer-sponsored qualified retirement savings plan — then only a certain portion of payments from the annuity will be subject to taxes.

Additionally, the type of annuity will affect how taxes are calculated.

“Some types of annuities can help minimize taxes a bit, but there can be other considerations,” said Mark R. McManus, a senior vice president with Baystate Financial in Southborough, Massachusetts. “You don’t want the taxation tail wagging the investment dog.”

To understand all the tax ramifications, it’s helpful to have some context.

Annuity basics

An annuity is a contract where, in exchange for a payment or a series of payments, an insurance company will provide a guaranteed stream of payments. Depending on the type of annuity, this income stream can begin either immediately or at some point in the future.

Those annuities that start payments right away are called immediate or income annuities.
Those that allow for a period of investment and growth are termed deferred annuities. Some annuities grow funds at an interest rate guaranteed by the carrier. Others allow funds to grow in coordination with various market vehicles.

Distributions from either type of annuity — immediate or deferred — will be taxed. But there will be differences depending on how the income from the annuity is distributed — through withdrawals or through annuitization.

A road map might be helpful:

Taxation of Nonqualified Annuities

Deferred Annuities

Income Annuities

Immediate
Deferred

Deferred annuities

In the case of deferred annuities, taxation will depend on whether you received payments through annuitization or withdrawals.

Annuitization is the point at which the annuity investment is converted into the stream of guaranteed income payments. (Learn more: What is annuitization?)
Withdrawals, on the other hand, can be taken from an annuity under certain conditions and time parameters.

Taxation of withdrawals from a deferred annuity

Many owners prefer to withdraw funds from their annuity contract as needed during their retirement years.

For tax purposes, withdrawals from nonqualified deferred annuities are deemed to come from earnings first and then from the investment, or “cost basis,” in the contract. This is commonly referred to as the “last in, first out (LIFO)” rule.¹

Here’s an example:

Let’s assume Patrice, at age 55, invests $50,000 into a nonqualified deferred annuity.

Ten years later, at age 65, the value of the contract has grown to $90,000.
Patrice withdraws $45,000 for a down payment on a condominium in Florida.

The taxation of the withdrawal would be calculated as follows:

The $40,000 of earnings would be subject to ordinary income tax.
The remaining $5,000 would be a tax-free return of basis.

After the withdrawal, the basis in the contract would be reduced to $45,000. Two years later, when the cash value of the contract had increased to $49,000, Patrice withdraws an additional $3,000 from the contract. Because the gain at the time of the withdrawal is $4,000, the full $3,000 withdrawal would be taxed as ordinary income. The basis in the contract would remain at $45,000.

“Many people think the gains in annuities are taxed as capital gains — they’re not,” noted Thomas. “The gains generated in an annuity are taxed as ordinary income. So, gains in a nonqualified deferred annuity are taxed just like money in your pretax 401(k).”

A 10-percent penalty tax generally applies to the taxable amount of withdrawals from nonqualified deferred annuities made before the owner attains age 59½. However, several exceptions apply to this tax.

Taxation when a deferred annuity is annuitized

When an annuity owner annuitizes all or a portion of their contract value, part of each annuity income payment received will represent a return of the nontaxable investment (again, the cost basis), with the remainder representing taxable income (the investment growth).

The exclusion ratio — the investment in the annuity contract divided by the total payments expected to be received — will be used to determine how much of each distribution will be taxed.

Let’s look at the following hypothetical example:

Juan owns an annuity with a $50,000 basis and a current value of $80,000. Juan reaches retirement and wants to annuitize the contract.
With a 20-year life expectancy, he selects an income option that will pay $425 per month for life, providing a projected cumulative payout of $102,000.

What percentage of the $102,000 is taxable and what percentage is nontaxable?

The $50,000 basis divided by the $102,000 projected cumulative payout equals an exclusion ratio of 49 percent.
The nontaxable portion of each $425 monthly payment received in the first 20 years is $208.25 ($425 X 49 percent).
The remaining $216.75 is subject to ordinary income tax.

The full $425 monthly payment will be taxable income if Juan lives more than 20 years, since the entire basis in the contract would have already been returned to the annuity owner.

Income annuity taxation

Income annuities are designed to provide guaranteed income for the rest of your life.

An immediate annuity, also called an immediate income annuity or single premium immediate annuity (SPIA), offers you income typically starting within 13 months of a single lump-sum purchase payment.
A deferred income annuity guarantees income at a specific point in the future and generally allows you to make multiple purchase payments over time (with some restrictions).

Immediate annuity taxation

Taxes on the distribution payments from an immediate annuity will again depend on the exclusion ratio — how much money was invested and what the return of that money will be over the length of the payments.

For example, you buy an immediate annuity to provide a guaranteed stream of income through your retirement years. You're expected to live to age 85, which the insurance company will use to calculate distributions.

The principal portion of your distribution payments will be tax-free and divided equally among the expected payments to age 85.

The earnings portion will be taxed as ordinary income.

If you live longer than 85, the distributions will be taxed as ordinary income because the principal has run out.

Deferred income annuity taxation

Again, taxes won’t apply to the after-tax money that you invest in a deferred income annuity but will be owed on any earnings that annuity investment produces.

As discussed earlier, the exclusion ratio will be used to determine how much of each payment will be taxed. But the return of the investment over the length of payments will include investment growth up to the point where the stream of payments starts.

Annuity aggregation and taxation

Another annuity tax rule that may affect the taxation of withdrawals is aggregation. All deferred annuity contracts issued by the same company, to the same owner, during the same calendar year will be aggregated together and treated as one contract for purposes of computing the taxable amount of distributions from any of those annuities.

For example, let’s assume Sally owns two annuities purchased from the same company in the same calendar year.

One annuity has a cost basis of $50,000 and a value of $100,000.
The other has a cost basis of $50,000 and a value of $55,000.

Sally wants to withdraw $20,000.

Without aggregation, she can withdraw the entire $20,000 from the lower value annuity and only be subject to tax on $5,000.
But aggregation combines the two annuities, so there is a total of $55,000 of gain.

Therefore, the entire withdrawal of $20,000 would be subject to taxation.

State taxes on annuities

In addition to federal taxes, annuities may be subject to state income taxes. How much those taxes will be may depend on the state where the annuity contract was issued and/or where the purchaser lives.

Some states follow the federal government’s lead, while others have different tax rules or exemptions.

For instance:

Some states have no income tax.
Some states don’t tax certain types of retirement income.
A few states may only tax a portion of annuity income.
Others offer tax credits or deductions for annuity contributions or payments.

Therefore, it is important to consult a tax professional or the annuity provider to determine the state tax implications of annuities.

Conclusion

In the end, federal taxation of annuities basically depends on whether the annuity was funded with pretax or after-tax money. For pretax money, like that in a qualified retirement plan, distributions will likely be taxed as ordinary income. For after-tax investments, the earnings will be taxed as ordinary income, but calculated differently depending on how the distributions are made.

Given the complex nature sometimes involved in setting up retirement streams of income, many people opt to consult a tax specialist, financial professional, or both to help advise on solutions.

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¹There is an exception to this rule for annuity contracts that were purchased prior to August 14, 1982. For these contracts, earnings are taxed last. In other words, withdrawals first come from the tax-free basis in the contract and only when basis is exhausted will distributions of taxable gains in the contract be taxed.