“How is My Annuity Going to Be Taxed?”

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

“How is my annuity going to be taxed?” It’s a question that’s asked frequently, but one that can have several different answers. That’s because an annuity can be taxed differently depending on the type of annuity you are receiving distributions from, as well as the type of the account it’s in.

First, let’s make sure that we understand annuities generally fall into one of two categories. Either they are in “deferred status” or they have been “annuitized.” With a deferred annuity, you generally still exercise some control over your investment. On the other hand, annuitization is generally an irrevocable election where you essentially turn your money over to an annuity carrier in exchange for a series of payments.

Distributions of deferred annuities (that have not been annuitized) held in non-qualified accounts are taxed on what is known as a LIFO, or last-in, first-out basis. This means that if you have any earnings in your annuity, they are the first dollars considered to be distributed and are taxable as ordinary income. Only after you have exhausted your earnings will you receive distributions of principal – your initial investment in the contract – back tax free.

Example: You purchase a deferred annuity for $100,000 and the value has now grown to $115,000. While still in deferred status, you take a $12,000 distribution. The entire distribution would be taxable as ordinary income because you have not yet exhausted your $15,000 of earnings. If, instead of taking $12,000 you took $18,000, you would have taxable income of $15,000 and a return of basis of $3,000.

Distributions of annuitized annuities purchased with after-tax funds are taxed a little bit differently. Instead of being taxed on a LIFO basis, a portion of principal is returned with distributions. If you’ve annuitized your IRA over a specific number of years (i.e., 20 years), your principal will be distributed to you evenly over those years. If, on the other hand, you’ve annuitized your annuity contract over one or more life expectancies, your principal will be returned to you over the predicted life expectancy. An annuity company will calculate this “exclusion ratio” for you and can tell you how much of your distributions will be taxable and how much will be tax free.

Example: You purchase an annuity for $100,000 that is annuitized over 20 years and guarantees annual payments of $6,500. Each year, $1,500 of your distribution will be tax free and $5,000 ($100,000/20 = $5,000) will be taxable.

What if, on the other hand, you purchase your annuity with traditional IRA or Roth IRA money? Well here’s where people get confused. For the most part, you can throw away everything above, because when an annuity is purchased with retirement account money, distributions from that investment follow the applicable rules for the specific retirement account.

For example, if you purchase an annuity with traditional IRA money and start taking distributions, for tax purposes, it really doesn’t matter whether it’s been annuitized or not. If those distribution checks are going straight to you (i.e., the money is no longer in an IRA), then the entire amount is generally taxable because IRAs are generally funded with pre-tax dollars.

Similarly, if you purchase an annuity in a Roth IRA and begin to take distributions, the tax impact will be determined based on the Roth IRA rules. So, for instance, if you are already age 59 ½ and have owned a Roth IRA for at least 5 years, any distributions from Roth IRA-owned annuities will be considered qualified distributions and will be completely tax free.