Are annuities taxable? Tax implications, penalties & rules for qualified vs. nonqualified annuities

Annuities can provide a reliable income stream in retirement. But as with other money you're relying on in retirement, it's important to know if annuities are taxable. Taxes in retirement affect the amount you have available to cover your living expenses, pursue your passions or give generously to the people and causes you care about.

How much is taxed on annuity income depends on the type of annuity, the timing of withdrawals and whether you fund the annuity with pre-tax or post-tax dollars. Read on for details about how annuities are taxed so you can make confident, informed financial decisions.

Annuities are taxable, but how they are taxed depends on whether they are qualified or nonqualified. Qualified annuities, like those funded with pre-tax dollars, are fully taxable upon withdrawal. Nonqualified annuities are funded with after-tax dollars, then upon withdrawal are taxed on the earnings first, with the original contributions coming out tax-free.

The entire payout is subject to income tax if you purchase the annuity with pre-tax dollars, which you might do within a traditional IRA. However, if you use post-tax dollars, only the earnings portion of your withdrawals will be taxed. Understanding this distinction can help you avoid surprises when you start drawing income from your annuity.

Understanding the tax treatment of annuities begins with knowing whether they are qualified or nonqualified annuities.

• A qualified annuity is typically funded with pre-tax money. You generally purchase qualified annuities in a tax-advantaged retirement plan like a traditional IRA.
• A nonqualified annuity is funded with after-tax dollars, meaning you purchase these annuities with money on which you've already paid income taxes.

Next, we'll explore how these differences affect taxation.

After you purchase an annuity, your value may grow at a fixed rate of interest or fluctuate according to the variable investment options you select over time. This happens during the accumulation phase, when you contribute money through a series of payments or a lump sum. Any growth during the accumulation phase is tax-deferred, so you don't have to worry about paying taxes on earnings or interest until you begin receiving payouts (usually after you retire).

It's important to note that only deferred annuities have an accumulation phase. With these annuities, you receive payouts in the future, leaving time for growth potential. An immediate annuity doesn't have an accumulation phase because it converts one lump-sum contribution into a stream of income, with payouts starting within a year.

Whether you take withdrawals or set up a guaranteed annuity payout stream, the full amount will be taxable.

While Roth IRAs are qualified annuities in that they remain tax-deferred until distribution, they are funded with after-tax contributions. If Roth IRAs rules are followed, all withdrawals and guaranteed annuity payouts will be tax-free.

During the distribution phase, you may begin to receive payouts. You may elect to set up systematic withdrawals or just take withdrawals whenever you would like. You also have the option to elect to a guaranteed payout stream. This means you select a guaranteed payout that can last through your lifetime or a set number of years.

Whether you take withdrawals or elect to annuitize, you don't have a choice in how much earnings versus contributions you receive. For withdrawals, earnings are paid out first, meaning you pay taxes on the full withdrawal amount until all the earnings have been paid out of the annuity. If you elect to set up a guaranteed annuity payout stream, each payment uses an "exclusion ratio" to determine how much of your payout is considered income versus how much is a nontaxable return of your principal. Your insurance company should provide you with a form to complete your tax return that indicates how much is taxable.

Say Lucia contributes $200,000 in tax-deductible traditional IRA contributions over the years. Her IRA is in a qualified annuity. Over time, her balance grows to $400,000. When Lucia retires and begins withdrawing $20,000 annually, the entire amount is taxable because she has not paid any tax on either her contributions or the growth in the annuity.

Instead, assume Lucia rolled over her 401(k) balance to a traditional IRA immediate annuity. Her guaranteed annuity payouts will be fully taxable as she has not paid any tax on either her contributions or their earnings.

Darius invests $100,000 in a nonqualified annuity, which grows to $150,000. When Darius withdraws $10,000, the full amount is taxable because earnings are paid out first. After the earnings ($50,000) are exhausted, he can withdraw his original $100,000 in principal tax-free.

If Darius had purchased an immediate annuity with $100,000 and receives monthly guaranteed annuity payouts of $500 over 20 years, an exclusion ratio would be applied to his payout. Using an exclusion ratio, a portion of each payout is considered a return of principal and is tax-free while the balance is taxable income.

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When inheriting an annuity, the tax treatment depends on the type of annuity and the relationship between the original owner and the beneficiary.

If a spouse inherits an annuity (qualified or nonqualified), they typically can treat the annuity contract as their own. This means they continue to enjoy the tax deferral and only pay taxes on withdrawals, just as their spouse did.

Non-spousal heirs, such as children or grandchildren, have different options based on whether the annuity is qualified or nonqualified. Qualified annuity distributions to beneficiaries will be fully taxable and are subject to IRS-required minimum distribution rules. Nonqualified annuities must be distributed within five years of death unless the beneficiary elects for a guaranteed annuity payout within one year. Either way, a portion of each distribution or payout is considered a return of principal and is tax-free, while the balance is taxable income.

Annuities are valuable tools for creating a steady income stream in retirement, but their tax treatment can affect how much you ultimately keep. Here are a few strategies for reducing taxes on different types of annuities.

Qualified annuities are typically funded with pre-tax dollars, meaning all withdrawals are taxed as ordinary income. To reduce the tax impact:

• Delay distributions. Waiting until you are in a lower tax bracket to take distributions can reduce the tax rate applied to your income. Keep in mind that qualified annuities are subject to required minimum distribution rules once you reach a certain age.
• Strategic withdrawals. Avoid large withdrawals in one tax year, which can push you into a higher tax bracket. Instead, opt to keep your annual withdrawals at an amount that keeps you at the tax rate you expect.

Nonqualified annuities are funded with after-tax dollars, so only the earnings portion of withdrawals is taxable. Here are some planning tips:

• Leverage tax-deferred growth. Delay withdrawals as long as possible to take full advantage of tax-deferred growth.
• Coordinate with other income sources. Manage withdrawals to avoid overlapping with other taxable income that could increase your overall tax rate.
• Annuitize payments. The exclusion ratio applied to annuity payouts ensures a portion of each payment is treated as a return of principal and remains tax-free. On the other hand, withdrawals would be fully taxable until all the earnings have been exhausted.

Early withdrawals from an annuity—before age 59½—are subject to a 10% federal tax penalty in addition to income tax on the taxable portion of the distribution.

To avoid tax penalties, schedule withdrawals to occur after age 59½. If you must take early withdrawals, take advantage of any exceptions that may qualify for penalty-free withdrawals. Some exceptions to the 10% penalty include total and permanent disability or using the money to pay for:

• Qualified higher education expenses
• Deductible medical expenses over 7.5% of adjusted gross income
• Health insurance premiums while unemployed
• Birth or adoption expenses (up to $5,000)
• Losses sustained due to a federally declared disaster (up to $22,000)
• Personal or family emergency expenses (up to $1,000 per year)

It's best to check with a tax advisor to determine if you qualify ahead of taking an early withdrawal from an annuity.

Work with your financial advisor and a tax professional to understand your annuity's tax consequences. To learn more about the types of annuities available and how they can help you reach your retirement goals, connect with a Thrivent financial advisor near you.