A reader of mine recently asked me a question about how annuities are taxed. Specifically it pertained to which portion of an annuity is taxable.
This is a very important question, because if you don’t know the right answer to it you may unknowingly pass up on an annuity as part of your portfolio.
So let’s get started…
How are annuities taxed?
Annuities are taxed depending on what kind of money is in them. If it is traditional IRA money that has never been taxed before, then all of it is taxed when you pull it out of the annuity.
This is the same way any traditional IRA is taxed, even if the funds are not invested in an annuity. If the IRS allowed you to use pre-tax dollars to contribute to your IRA they are ready to tax that money at some point in the future. When you withdrawal the funds from your traditional IRA you get taxed.
The reason for your withdrawal may be because you need the extra cash for a one-time purchase, you may have turned your annuity into a permanent income stream with recurring withdrawals, or maybe because you have turned 70 ½ and must take required minimum distributions per IRS rules.
Now if the funds you invested in an annuity were Roth IRA funds, then none of it is taxable when you make a withdrawal. That is the nature of a Roth IRA. You use after-tax dollars to contribute to a Roth IRA, and then the gains and original deposit are all pulled out with no tax assessed against them.
If the funds you put into an annuity are non-qualified funds then only the growth above the original deposit is taxable. The original deposit itself is not taxable again.
This is an important part to keep in mind. The original deposit has already been taxed if it is non-qualified money. This is money that you have earned, paid taxes on, and saved what was left over. So the original deposit will not be subject to income taxes again.
In fact, my reader that asked me about the taxation of annuities was concerned that the entire amount put into the non-qualified annuity would become taxable again. This was leading him to believe that annuities were a horrible way to invest because it would subject his already taxed original deposit to additional taxation. But that is not the case.
The original deposit is not subject to additional income taxation. Only the gains inside the annuity are subject to income taxation when using non-qualified funds.
At what tax rate are annuities subjected?
Annuities are subjected to the income tax rate. Depending on the owner’s marginal income tax bracket this could vary. Typically, income tax rates will be higher than capital gains tax rates, at least under current tax law.
Then what is the benefit of owning an annuity if it subjects the earnings to a higher tax rate? Other than the income guarantees and principal protection guarantees, the other benefit would be:
When you put non-qualified money inside an annuity it can grow tax deferred. This is the benefit of a traditional IRA too. The money grows tax deferred until it is withdrawn from the annuity. The same is true for traditional IRA’s too, even when they are invested in mutual funds.
Putting traditional IRA money inside of an annuity does not give you any additional tax deferral benefit. However, there are other benefits you may want for your traditional IRA money inside of an annuity. These include income guarantees, principal protection on fixed annuities, even some additional help with long-term care in some cases.
How are annuities taxed if my kids inherit one from me?
The answer to this question, again, will depend on what kind of money is in the annuity.
If it is a traditional IRA, then all of the proceeds are subject to your beneficiary’s income tax rate, which depends on which marginal income tax bracket they are in.
This is the same way any inherited traditional IRA is taxed when your beneficiaries inherit it. The way to help reduce taxation on inherited traditional IRA’s (whether they are inside an annuity or a mutual fund) is to stretch out the distributions as much as possible.
Since distributions from a traditional IRA count as additional income to the owner, they must be careful about pushing themselves into a higher marginal tax bracket. Taking one large lump sum from an inherited traditional IRA is one way to help push you into a higher tax bracket. This means Uncle Sam gets a higher percentage of the proceeds.
By stretching distributions out over a time frame, it can help keep the recipient in a lower tax bracket.
With a Roth IRA the proceeds are tax free for the beneficiary. So they could take the lump sum the day after you die and not worry about paying tax on it or being pushed into a higher tax bracket.
However, the new owner may benefit from stretching out the distributions of a Roth IRA as much as the IRS will allow. This is because all the growth inside the account will grow tax free. So it’s nice to take advantage of that and make the account last as long as possible.
With non-qualified money, only the gains above the original deposit will be taxable for the beneficiary. And they will be taxable at the beneficiary’s marginal tax bracket.
This means it may benefit the beneficiary to stretch out the distributions as much as possible to help prevent going into a higher tax bracket.
It’s good to know how these things work. My reader who originally had the question thought that the original deposit would be subject to taxation again on his non-qualified annuity. That certainly would make a non-qualified annuity VERY unattractive.
But understanding how it works makes all the difference when deciding what to do with your retirement funds.
To learn more about annuities be sure to download my free ebook “How To Avoid Annuity Traps.”