Are annuities taxable? Differences between qualified & nonqualified annuities

There are many different types of annuities, each with a different set of tax rules and benefits. Some annuities offer tax-free growth, while others let you defer taxes until retirement. Whether or not annuities are taxable depends on a couple of factors, and understanding the rules could help you save more of your hard-earned money. 

This article will explain how you’ll pay taxes on an annuity. Discover how annuity income is taxed, the differences between qualified and nonqualified annuities, and tips for managing your investments.

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What are annuities?

An annuity is a financial contract with an insurance company. In exchange for one or several contributions, the institution will send you payouts when the account matures.

You can customize your annuity by including additional features called riders. These optional add-ons offer benefits not included in the original contract. For example, you can add a rider to guarantee income for life or to ensure your beneficiaries receive funds after you pass away. 

When choosing an annuity, one important consideration is your tax bracket projections. If you anticipate being in a lower bracket, a qualified annuity may be ideal, as it allows you to fund it with pre-tax dollars and pay taxes on withdrawals later. But a nonqualified annuity could benefit those expecting to be in a higher tax bracket during retirement. This option uses after-tax dollars, so you only owe taxes on the earnings during withdrawals.

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How are annuities taxed?

Annuity payments are taxed differently depending on the type you choose and how you withdraw your money. Below, you’ll find a breakdown of the different annuity types and how their taxation works. 

Qualified annuity taxation

Qualified annuities are funded with pre-tax dollars from sources like a traditional IRA or 401(k). This means you don’t pay taxes on your initial contribution, and your overall taxable income for the year will be lower. When you start taking withdrawals, your entire payout will be subject to income tax, including funds from principal and interest.

Worth noting: A few additional fees may apply to these types of accounts. For instance, if you withdraw money before the age of 59½, you might need to pay a 10% IRS penalty on top of the income tax. 

Additionally, at 73, you must start taking the required minimum distributions (RMDs). The IRS calculates these minimums based on your savings and life expectancy. You’ll pay regular income tax on the distributions, and failing to withdraw the required amount may result in a 25% excise tax.

Nonqualified annuity taxation

With nonqualified annuities, you fund the account with after-tax dollars. Since you’ve already paid taxes on the initial contribution, you’ll only owe tax on the earnings when you withdraw.

Like qualified annuities, if you withdraw those earnings before age 59½, you may also face a 10% IRS penalty on the taxable portion. But you don’t have to take RMDs with this type of account.

Fixed and variable annuities taxation

How your annuity grows affects its tax treatment. With fixed annuities, your money compounds at a guaranteed interest rate. When you withdraw funds, the IRS taxes the interest earned as regular income. 

For variable annuities, your returns depend on the performance of investments like mutual funds. Although growth may come from dividends or capital gains, the IRS taxes all withdrawals as ordinary income without offering the lower tax rate usually associated with capital gains.

Immediate and deferred annuities taxation

Both immediate and deferred annuities offer qualified and nonqualified options, affecting whether you pay income taxes on the principal. The difference lies in how quickly you’ll start paying taxes. 

With immediate annuities, you start receiving payments as soon as one month after you buy the annuity, so you’ll owe taxes sooner. Deferred annuities, however, have much longer maturity dates, so you may not owe taxes on them for decades after purchase.

Roth accounts taxation

Roth annuities are funded with after-tax dollars, so you don’t get a tax break up front. But the payoff is worth it: If the account has been open for at least five years and you start withdrawing after 59½ , both your principal and earnings are tax free. And if you start taking payments early, only the gains are taxed, not the contributions.

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How are inherited annuities taxed?

Inheriting an annuity involves specific tax rules that can impact your financial planning. Understanding these regulations helps you manage your inheritance wisely.

Value of the estate

Starting in 2024, estates with a total value exceeding $13.61 million may be subject to federal estate taxes. This tax applies per individual, so married couples have a $27.22 million limit. The entire estate, including the total value of any annuities, faces these taxes.

Estates below this value avoid these federal estate taxes, but you’ll still owe income taxes on the annuity based on its classification. 

Qualified vs. nonqualified annuity inheritance

If you inherit a qualified annuity, you’ll pay ordinary income tax on every withdrawal. The IRS doesn’t separate the original contributions from the earnings, so the entire amount is taxable as income.

With a nonqualified annuity, you’ll pay tax on the earnings. You don’t owe on the original contributions because the person who funded the annuity already paid taxes on that money.

Payment schedule

If you decide to take periodic payouts, you’ll pay ordinary income taxes on each installment. But lump sum payments are subject to taxes for the entire annuity at once, which can be costly.

Rather than receiving payments right away, spouses can roll annuity inheritance over into their own IRA. These contributions will be taxed like the rest of their retirement accounts. Non-spouse beneficiaries don’t have access to this option.

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Common tax-reduction strategies for annuities

Reducing your annuity’s taxable income might sound complicated, but with some planning, you can keep more of your hard-earned money.

Here are some practical tips to help you maximize your annuity while reducing your taxes:

• Use tax-advantaged accounts: Using Roth IRA funds to invest in an annuity gives you additional tax benefits. You can only contribute to these accounts with after-tax dollars, so you’ll never owe on the principal during withdrawals. And if you follow the regulations, you won’t pay taxes on earnings, either.
• Leverage tax-free benefits: If you use a nonqualified annuity to grow your money with after-tax dollars, when you withdraw, you only pay taxes on the earnings — the original investment remains tax-free. It can also be beneficial to invest in qualified annuities to delay tax payments until you’re in a lower tax bracket during retirement.
• Let your money grow tax-deferred: Most annuities provide tax-deferred growth, allowing your money to compound without incurring yearly taxes on your gains. And typically, annuities are taxed when distributed, meaning you only pay taxes as you receive payments. 

Talk to the experts: Tax rules can vary depending on the type of annuity you purchase, so it’s important to review the details or consult a financial professional before investing.