The taxation of annuity income depends on the type of annuity you have – and there are many different types of annuities to choose from in today’s financial marketplace. In addition to fixed, indexed, and variable annuities, there are also immediate and deferred, as well as qualified and non-qualified annuities.
While all of this might initially seem like a big bowl of annuity vegetable soup, understanding how the letters all line up can help you to anticipate any tax consequences you could incur and even to reduce or eliminate tax when you can.
Understanding Taxation of Annuity Income
There are several different ways to categorize annuities. For instance, immediate annuities will start to pay out income right away – or very soon after you make a contribution to it. On the other hand, deferred annuities don’t pay income until a time in the future.
During the “accumulation period” (i.e., the time before income starts from an annuity), the growth in the annuity is tax deferred. This means that no tax is due on the gain until the time of withdrawal.
A different category has to do with how the return in an annuity is generated. In this case, an annuity can be:
Fixed annuities offer a set rate of return – no matter what is happening in the stock market. In exchange for a lower return, fixed annuities offer safety of principal, along with a known amount of income payout.
A fixed-indexed annuity bases its return in large part on the performance of one or more market indexes, such as the S&P 500. When the index performs well, a positive return is generated – oftentimes up to a cap, or limit. If, however, the underlying index(es) performs poorly, no loss is incurred.
Variable annuities base their return on equity investments like mutual funds. Typically, the upward return potential on a variable annuity is great. However, there is also risk of loss if the investment(s) being tracked perform in the negative.
Annuities can also be categorized as qualified or non-qualified – and this is where you can determine how much of the income from the annuity will be taxable. For instance, non-qualified annuities are not held in retirement accounts like IRAs.
These annuities are often purchased with personal, after-tax, funds. However, the growth that takes place in the annuity is tax deferred. Therefore, income that you receive from a non-qualified annuity will be partially taxable.
In this case, each payment will consist of part non-taxable return of principal, along with part taxable gain. Once you have received back the equivalent of your contribution(s), 100% of the income from the annuity will be taxable.
Qualified annuities are purchased with pre-tax dollars. As an example, if you contribute pre-tax funds into a traditional IRA, and you then purchase an annuity with those dollars, none of the money in the annuity has yet been taxed. Because of that, when you receive income from a qualified annuity, 100% of the payment(s) will be taxable.
In addition, unlike non-qualified annuities, a qualified annuity must abide by the IRS’s required minimum distribution (RMD) rules. This means that you must begin taking at least a minimum amount of withdrawal when you turn age 73 (in 2023).
Qualified vs. Non-qualified Annuities
|Qualified Annuity||Non-qualified Annuity
|Contribution source||Before tax||After tax
|Taxation of payout(s)||The full distribution is taxed as income||Only the gain is taxed
|Must being taking distributions||By age 73 (in 2023)||No required minimum distribution requirement
Will You Have Enough Net Spendable Income in Retirement?
Annuities can provide a viable solution to filling in a retirement income “gap” between your living expenses and income from other sources like Social Security. Because there are so many different types of annuities, though, it is critical that you understand how they work – and how they may or may not be beneficial to you, based on your specific needs and goals.
At Annuity Gator, we focus on educating consumers (and financial professionals) on how annuities work, and where certain types of annuities might fit into an overall retirement plan. So, if you would like more details, feel free to set up a time to chat with an Annuity Gator retirement income expert.
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