Annuities Tax


An Annuities Tax is a form of a contract between you the investor and another party, usually an insurance company or a financial institution. As the investor, you pay a specific amount of money to the insurance company or the financial institution over a specific period of time. Once you have completed your payments over that period of time which can be anywhere between 20-25 years, you start receiving the benefits from your investments. You begin withdrawals at age 59 1/2 years and can receive these as either a lump sum or in several amounts over a determined time frame.

An annuity therefore works like insurance, retirement or savings plan. It can assure you of a regular income once you retire, finance a college plan for your kids or simply to enable you to live comfortably in your old age. The amounts of money you contribute and expect to receive back differ according to the type of annuity plan you choose. Some examples of these annuity plans are: fixed, single, variable and flexible.

You might ask how does an annuity tax work, and how does this affect IRA and your tax extension? The real advantage of an annuity is that it is classified as a tax-deferred retirement plan. Therefore, no annuity tax is applied until payouts begin. One is not expected to pay any tax while contributions or investments are being made.

You or your employer can also invest a portion or your entire IRA into an annuity. For instance if you have extra money from your IRA or it has been completely paid, you might decide to convert these funds into an annuity. In this case, it becomes a qualified annuity. Annuity tax treatment for qualified annuity is different. Funds which are invested into a qualified annuity are untaxed money or pre- tax/before tax dollars. This means that a qualified annuity is taxed on the capital, interest and gains once withdrawal of benefits begins.

For non-qualified annuity, funds which are put into these are taxed already. As such, taxes apply only to the earnings and gains and not on the capital as soon as withdrawal begins. An annuity withdrawal tax is collected once you start receiving your annuity payments but only on the extra earnings made by your contribution. The original investment will still be untaxed as they have been taxed already. The bottom line is, whether it is qualified or non-qualified annuity, an annuity tax is applied on earnings, gains and interest.

What if you decide to cash out before for any reason? If you opt to cash out or surrender the entire value of your annuity before you are eligible to receive cash out, an annuity tax penalty applies (about 10%) plus a surrender charge which will be applied by the investment company which held your money. In some cases, the IRS might waive the 10% penalty fee for reasons such as financing education or buying a first home. The investment company will still apply the annuity surrender tax which is about 7%.


Once you purchase a deferred annuity for yourself, the amount that you invest into it will be your cost basis, whether the deferred annuity is variable or fixed. From that point of view, any investment loses or gains are tax deferred. That means you do not have to report investment, dividends or interest gains which you earn every year on your tax return. However, tax deferred isn't the same as being tax-free.

So, if you withdraw a certain amount of money from such a deferred annuity, the thing that is considered withdrawn first is the gain, and thus all the withdrawals that you make will be taxed at the ordinary income tax rate. For example, all the withdrawals that you make from your annuity when you are bellow 60 years of age will be taxed with 10% penalty.

In case you choose to purchase an immediate annuity, part of the payments that you will get will be considered as a return of your money (a return of principal), while another part will be considered as interest. You will have to pay the taxes for the part which is considered to be an interest, but you won't have to pay taxes for the return of principal part. You will be provided with a tax statement from the insurance company. In it you will find detailed information about which part of the money is taxable, which isn't and how much exactly the taxes are.

Before you purchase your annuity from the insurance company, they can tell you about your exclusion ratio. This ratio is the monthly payment amount that may be excluded from your taxes. In case you convert your deferred annuity to make it an immediate one, the annuity tax is going to function just like it will for an immediate annuity, with interest and return of principal portions.

Annuities can be defined as a tax-deferred retirement plan. However, they differ from 401k plans in that they are funded by using income which has already been taxed. Tax on capital gains, interest and other earnings related to your annuities contributions is deferred until the time comes for you to start withdrawing from the plan.

The annuity payments need to be divided between the contributions and the earnings related to those contributions. You get taxed based on the earnings and not the initial contribution. The taxable portion of an annuity can be calculated with the help of the Simplified Method Worksheet. The total annuity payments need to be reported on Form 1040.

A fixed or a variable annuity can prove to be a great retirement vehicle for anyone. Annuities offer the same kind of benefits as the rest of the similar retirement plans. They are quite similar to the employee-sponsored 401k plan or the traditional IRA accounts. However, annuities do not come with contribution limitations, income limitations and mandatory withdrawals. This is what makes them different from the 401k plan and IRA. The contributions you make are taxed right away and your retirement earnings can grow free of any additional taxes.

Annuities can be separated into two major categories: variable and fixed. A fixed annuity goes with an interest rate which is predetermined and remains the same for the time the contract is valid. The premiums, when it comes to variable annuities, are distributed among bonds, stocks and money market accounts. This makes this type of annuities quite similar to traditional IRA accounts and the 401k plan. Fixed and variable annuities are more than just a retirement vehicle. They include a certain insurance component, too. Depending on the choice of annuity, they come with various death benefits, benefits for the beneficiaries and life-long payments for the policy 401k holder.