How Annuities Are Taxed

I enjoyed your article Guaranteed Income for Life. Now I'm wondering how annuities are taxed. Can I buy an annuity with funds in my IRA? And what if I use after-tax dollars in a nonretirement account -- is a portion of each payment considered a return of principal?

The tax rules vary based on the type of annuity and how you take the money.

You can buy an annuity with funds in your IRA, and if you use pretax money from an IRA or a 401(k) to purchase the annuity, then all payouts will be fully taxed. If you use after-tax dollars to buy the annuity, however, then a portion of the payouts will be a tax-free return of your principal. Either way, you'll have to pay any taxes that you owe on the annuity at your ordinary income-tax rate, not the preferable capital-gains rate.

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There are two types of annuities: immediate and deferred. With an immediate annuity, you hand over the principal to an insurance company and in return receive income for life. If you buy the annuity with after-tax money, then a portion of every payout represents a return of your original investment, and a portion is considered to be taxable earnings.

The money you invested in the immediate annuity is returned in equal tax-free installments over the payment period. If you have a life annuity with payouts that will stop when you die, for example, then that payment period is the IRS's life-expectancy number for someone your age. You'll owe taxes only on any portion of each payout beyond the tax-free return of principal.

Say, for example, you invest $100,000 in an immediate annuity and the annual payouts are $8,000. If the IRS considers your life expectancy to be 20 years, divide $100,000 by 20 to determine how much of each payout will be a tax-free return of investment. In this case, $5,000 of each $8,000 payout would be tax-free and $3,000 would be taxed at ordinary income-tax rates.

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If you have a deferred annuity, on the other hand, you may not receive any payouts for years. You usually invest money while you're working, and it grows tax-deferred in the account until you need it in retirement. If you have a variable deferred annuity with several mutual funds to choose from, you can shift the money from one fund to another without having to pay taxes -- as long as you don't withdraw the money.

You can also make tax-free exchanges from one deferred annuity to another as long as you don't withdraw the money in between, in a transaction called a "1035 exchange" (you may, however, have to pay a surrender charge to the insurance company if you switch out just a few years after buying the annuity).

You are taxed when you withdraw money from the annuity. If you buy the annuity with pretax money, then the entire balance will be taxable. If you use after-tax funds, however, then you'll be taxed only on the earnings.

If you cash out a deferred annuity in a lump sum, then you'll have to pay income taxes on all of the earnings higher than your original investment. If you take several smaller withdrawals from the account, however, then the IRS considers your first withdrawals to come entirely from interest and earnings. That means you'll be taxed on all of your withdrawals until you take out all of the interest and earnings. Only after that can the principal be withdrawn without taxes.

Say, for example, that you invest $25,000 in a deferred annuity and the investments increase in value by $20,000, making the account worth $45,000. The first $20,000 you withdraw is considered to be taxable earnings, so you'll pay taxes on all of the withdrawals up to that level before you can withdraw the original $25,000 investment without taxes.

Another withdrawal option is to annuitize a deferred annuity, which means you convert the deferred annuity to a lifetime income stream. In that case, you'll receive a portion of every payout as a tax-free return of principal, just as you would with an immediate annuity.