How Are Annuities Taxed?
One of the major features of a deferred annuity is tax deferral. But tax deferral does not mean tax-free income. The eventual tax treatment depends on how the annuity was funded, how distributions are taken and whether the contract is held inside a qualified retirement account.
Tax-deferred growth
Earnings inside a deferred annuity generally are not subject to federal income tax each year while they remain inside the contract.
Instead, taxation is generally deferred until taxable amounts are distributed through withdrawals, surrender, income payments or certain beneficiary distributions.
Tax deferred does not mean tax free
Tax deferral postpones taxation. It does not automatically eliminate it. When taxable earnings are eventually distributed, they are generally subject to ordinary federal income-tax treatment.
Qualified vs. nonqualified annuities
Nonqualified Annuity
A nonqualified annuity is generally purchased with money that has already been subject to income tax.
The owner's investment in the contract generally represents tax basis, while earnings grow tax deferred until distributed.
Qualified Annuity
An annuity may also be held inside a tax-qualified retirement arrangement such as an IRA or certain employer-sponsored retirement plans.
In that situation, the tax rules of the retirement account generally govern distributions.
An annuity inside an IRA does not create extra tax deferral
This is an important distinction.
An IRA, 401(k), 403(b) or other tax-deferred retirement account already provides tax deferral.
Purchasing an annuity inside one of those accounts does not create an additional layer of federal income-tax deferral.
Therefore, an annuity held inside a qualified account should generally be evaluated based on its other contractual characteristics, such as income guarantees, insurance features, downside protection, investment exposure, costs and liquidity.
How nonqualified annuity withdrawals are generally taxed
For many nonqualified annuity contracts purchased after August 13, 1982, withdrawals made before the annuity starting date generally are treated as coming from earnings first.
This is sometimes described as earnings first or LIFO — last in, first out taxation.
Assume an individual invested $100,000 of after-tax money in a nonqualified annuity and the contract later grew to $140,000.
The contract has $40,000 of gain.
If the owner takes a $20,000 nonperiodic withdrawal before the annuity starting date, that $20,000 would generally be treated as taxable earnings under the normal earnings-first rules.
Actual tax treatment depends on the contract and individual circumstances.
Are annuity gains taxed as capital gains?
Generally, taxable earnings distributed from a nonqualified annuity are taxed as ordinary income rather than at long-term capital-gains rates.
This can be an important consideration when comparing an annuity with a taxable investment account holding stocks, ETFs or other securities.
Tax deferral can have value, but the eventual tax character of the earnings should also be considered.
What happens when an annuity is annuitized?
Annuitization converts the contract into a stream of periodic payments according to the annuity's payout option.
For a nonqualified annuity, each payment may generally contain both a taxable portion and a tax-free recovery of the owner's investment in the contract.
Federal tax rules determine the portion of each payment treated as a recovery of basis and the portion treated as taxable income.
The calculation differs depending on the type of annuity and payout method.
The 59½ rule and the additional federal tax
Certain taxable annuity distributions received before age 59½ may be subject to an additional 10% federal tax.
However, federal law contains exceptions, and the rules differ depending on whether the annuity is qualified or nonqualified and the circumstances surrounding the distribution.
What is a Section 1035 exchange?
Section 1035 of the Internal Revenue Code can permit certain insurance and annuity contracts to be exchanged without recognizing gain at the time of the exchange.
A properly structured annuity-to-annuity exchange may allow the tax basis and deferred gain to carry into the replacement contract rather than triggering current income tax.
The exchange must satisfy federal tax requirements.
Before replacing an annuity, investors should compare surrender charges, existing guarantees, income riders, death benefits, crediting terms, fees, new surrender periods and compensation arrangements.
Read more about the economic side of an annuity replacement in the Annuity Fees & Costs Guide.
Does a 1035 exchange erase the taxable gain?
Generally, no.
A qualifying exchange generally defers recognition of gain rather than permanently eliminating the gain.
The tax basis and deferred gain generally carry forward into the replacement contract under applicable federal tax rules.
What happens when an annuity owner dies?
Annuities generally do not receive the same automatic income-tax basis treatment commonly associated with certain appreciated capital assets.
Beneficiaries may owe ordinary income tax on taxable annuity gain when distributions are received.
The exact treatment depends on factors including:
- Whether the annuity was qualified or nonqualified
- The owner's remaining investment in the contract
- The beneficiary relationship
- The available payout options
- The timing and form of distributions
Spouses may have options that differ from those available to non-spouse beneficiaries.
Required minimum distributions and qualified annuities
When an annuity is owned within an IRA or another retirement arrangement subject to required minimum distribution rules, those retirement-plan rules may continue to apply.
Purchasing an annuity does not automatically eliminate an individual's required distribution obligations.
RMD rules have changed repeatedly in recent years, so current IRS guidance and the specific retirement-plan rules should be reviewed.
Taxation should not be the only reason to purchase an annuity
Tax deferral can be useful, but it should be evaluated alongside the contract's other characteristics.
Liquidity
Surrender periods and withdrawal restrictions may limit access to money.
Fees & Costs
Some contracts have explicit fees while others may impose economic tradeoffs through crediting terms or withdrawal provisions.
Risk
Risk varies substantially among fixed, indexed, registered index-linked and variable annuities.
Income
Certain annuities may provide contractual lifetime-income features, subject to contract terms and insurer claims-paying ability.
Taxable account vs. nonqualified annuity
| Tax Consideration | Nonqualified Annuity | Taxable Investment Account |
|---|---|---|
| Annual tax on unrealized growth | Generally deferred | Generally no tax on unrealized appreciation |
| Interest/dividends | Generally deferred while inside contract | May create current taxable income |
| Taxable distributed gains | Generally ordinary income | May qualify for capital-gains treatment depending on asset and holding period |
| Tax-loss harvesting | Generally not available in the same manner | May be available |
| Contract restrictions | May include surrender periods | Depends on investments and account |
Annuity taxes for firefighters and first responders
Firefighters and other public employees may retire with several different tax structures at the same time.
These may include:
- Pension income
- DROP distributions
- Governmental 457(b) assets
- Traditional IRA assets
- Roth assets
- Nonqualified savings
- Annuity contracts
- Social Security income
The tax treatment of each source can be different.
Because of this, the decision to purchase or fund an annuity should be evaluated within the retiree's overall income and tax strategy rather than in isolation.
Common annuity tax misconceptions
“Annuity growth is tax free.”
Generally incorrect. Deferred annuity earnings are generally tax deferred, not automatically tax free.
“All annuity withdrawals are taxable.”
Not necessarily. Taxation depends on basis, gain, contract type, distribution method and whether the annuity is qualified or nonqualified.
“An annuity in an IRA gives double tax deferral.”
No. The IRA already provides tax deferral. The annuity should be justified by its other contractual features.
“A 1035 exchange eliminates the tax forever.”
Generally no. A qualifying exchange generally postpones recognition of gain rather than erasing it.
Continue learning
Understanding taxation is only one part of evaluating an annuity.
Continue with:
This material is provided solely for general educational and informational purposes and is not intended as individualized tax, legal, investment or insurance advice.
Federal and state tax rules are complex and can change. Tax treatment depends on contract type, ownership, funding source, distribution method and individual circumstances.
Consult a qualified tax professional regarding your individual situation.
Insurance guarantees are subject to the claims-paying ability of the issuing insurance company.