Although retirement may be a period of carefree relaxation, that doesn’t stop the IRS from mandating that you pay the taxes you owe.
With annuities, you pay a premium during your working years in exchange for payouts during retirement, allowing you to have an extra income stream you can rely on when you are no longer able or want to work. As with any income stream, though, annuities are subject to taxation by federal and state governments.
An annuity can be an excellent investment when planning for retirement, so long as you know and understand the taxes, you’ll be subject to during payout. Because of this, it’s essential to consult a tax professional when purchasing your annuity and in deciding to withdraw the money.
What is an Annuity?
Annuity income is a form of cash flow that is purchased ahead of time for an agreed-upon premium. This long-term investment is designed to ensure you don’t outlive your income in your retirement years and functions as both a primary income stream and a safety net.
While annuities are usually associated with pension plans and retirement planning, they aren’t exclusive to those purposes. They can be purchased in a lump sum as well as through a payment plan and (depending on the annuity contract) can begin paying out now or at any point in the future.
Additionally, annuities have different values depending on your payout strategy—that is, whether you decide to withdraw in payments or a single sum. By calculating the present value of an annuity, you can quickly determine which is more beneficial.
To calculate your annuities present value, simply follow this formula:
P = PMT x ((1 – (1 / (1 + r) ^ -n)) / r)
In this equation,
- P represents the present value
- PMT is the dollar amount of each payment
- R is the current discount or interest rate
- N is the number of payments left to receive
By following this formula, you can determine the present value of your annuity compared to what it would be if you withdrew it in payouts versus one lump sum. Generally, one will be higher than the other. Alternatively, you can also use an online annuity calculator to determine this number.
Overall, annuities are not meant to be short-term investment strategies, and they are instead best utilized for income and long-term earning.
Are Annuities Taxable?
In short, yes. Annuities are nearly always considered taxable income in some way or another.
Some annuities are tax-deferred, meaning they aren’t subject to being taxed until you decide to make an annuity withdrawal. Other annuities are taxed as you pay in, allowing you to spend less in taxes during your retirement years.
However, keep in mind that while annuities can present a long-term gain in the form of interest, they are taxed as regular income instead of capital gains—the former results in a higher tax bill than the latter.
Qualified Annuity Taxation
When your annuity is composed of money that has yet to be taxed, it’s considered a qualified annuity.
A qualified annuity is a tax-deferred annuity (also known as a tax-sheltered annuity) type where you pay taxes as funds are withdrawn. Usually, these types of retirement accounts are funded using money from your 401k or an IRA account, such as a Roth IRA.
However, if you’re paying into your annuity through your work, you’ll often have the option to choose whether you’d like this form of tax deferment or whether you want the money taxed ahead of time.
Non-Qualified Annuity Taxation
When you purchase your annuity (whether it is in payments or a lump sum) with dollars that have already been taxed, it’s considered a non-qualified annuity. Contrary to popular belief, however, this type of annuity is not necessarily tax-free; it is still taxed at the time of your retirement (just not as much).
The amount you’ll be responsible for on non-qualified annuities is calculated using what is called an exclusion ratio. This allows the IRS to determine how much of your pension is taxable and how much isn’t based on the amount you already paid in taxes on that money.
This ratio breaks your annuity income down into two parts: taxable and nontaxable. Your nontaxable portion is the amount you purchased the annuity for divided by the expected number of payouts in a specific period (a year, in the case of taxes).
Past that amount, any additional gains you made from your annuity (interest, investment earnings, etc.) are subject to income tax rates.
While this can result in having no tax bill at all, it more often provides you with a lower tax bill than the qualified annuity instead of eliminating it entirely.
What if I Withdraw my Annuity Early?
While you now know what to expect from different types of annuities in terms of taxation, it is vital to note that how and when you withdraw your funds can also affect how much you pay in taxes.
For example, withdrawing an entire lump sum before age 59 ½ can result in a ten percent penalty on your taxable portion (depending on whether it is qualified or nonqualified). Naturally, your tax penalty will be lower if you choose to receive it in payments, as you only pay taxes on the amount you see that year.
Annuity taxes can be quite daunting, but there is a light in the darkness: you will never pay taxes on your annuity until you begin withdrawing it. This allows you to do research, get prepared, and perhaps contact a tax accountant to help you understand how you can ensure that your tax bill gets paid on time.
At Borshoff Consulting, we pride ourselves on being Indiana’s leading tax expert, and we’re here to help you with any annuity tax questions you may have.
If you’re still confused about whether your annuity will be qualified or non-qualified, don’t know whether you should withdraw as a lump sum or periodic installments, or simply have questions you’d like answered, book a personal tax consultation today. We’d love to help.