At one point or another, you get stung with an unexpected expense. Like you take your car to the mechanic for what you assume is a simple brake pad replacement. But, you become flabbergasted when the mechanic informs you that the entire brake line needs to be replaced.
Of course, having an emergency fund in place would alleviate some of this pressure. But, what if you could be like Nostradamus and predict these types of expenses?
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Now, I’m not talking about recurring expenses that you at least have a ballpark figure on. These would be your mortgage, rent, car insurance, and utilities. Rather, this would be these out-of-the-blue expenditures like car or home repairs, medical bills, and your taxes in retirement.
I really want to hone-on on the latter because there’s a misconception your taxes will be lower in retirement. And, that’s not exactly true. After all, you’ll most likely still be earning an income from Social Security benefits and distributions from retirement accounts.
What’s more, in any retirement planning discussion, we couldn’t leave out the topic of how an income annuity might impact your taxes. And, more specifically how much you’re going to have to pay.
How is an Annuity Taxed?
As you have experienced working your entire life, income taxes are a significant part of your monthly budget. But, when you’re on a more limited budget in retirement, this becomes even more pertinent.
It is further complicated by the fact that income is taxed differently than many other investments and annuities. In fact, dividends from stocks and bonds are more tax-efficient than dividends from stocks.
But, wait a minute? Aren’t annuities tax-deferred?
Yes. All annuities grow tax-deferred. This means you don’t have to pay any taxes until you receive distributions from an accumulation annuity or a regular payment.
In contrast to non-qualified investment accounts or savings accounts, annuities may grow more over time since they compound undisturbed.
Despite the fact that annuity money grows tax-deferred, when you start withdrawing your money, that growth will be taxable as ordinary income.
How about the money you paid into your annuity? Depending on how you fund the annuity, either qualified or unqualified, this money is taxed differently.
In short, as long as you do not withdraw your investment gains from the annuity you will not be taxed on them. But, once you make a withdrawal or begin receiving payments, you’ll have to pay Uncle Sam.
Qualified Annuity Taxation
In general, annuities are taxed differently if they are in a qualified or non-qualified account. An annuity bought with pre-tax dollars is considered a qualified annuity. When you buy an annuity using a 401(k), 403(b), traditional IRA, SEP-IRA, or SIMPLE IRA, it will be classified as a qualified annuity since they are all funded with pre-tax dollars.
The payments you receive from this annuity type are fully taxable as ordinary income when they are withdrawn or received. If you withdraw from the annuity early, you may be charged your full contribution to the annuity plus the 10% penalty.
Lost? Let’s try to clarify what a qualified annuity is.
“A deposit into a qualified annuity is made without taxes being withheld,” explains Julia Kagan for Investopedia. As a result, this will minimize “the taxpayer’s income, and taxes owed, for that year. In addition, no taxes will be owed on the money that accrues in the qualified account year after year as long as no withdrawals are made.”
“Taxes on both the investor’s contribution and the investment gains that have accrued will be owed after the investor retires and begins taking an annuity or any withdrawal from the account,” continues Kagan.
“While distributions from a qualified annuity are taxed as ordinary income, distributions from a non-qualified annuity are not subject to any income tax on the contributions,” she notes. “Taxes may be owed on the investment gains, which generally are a smaller portion of the account.”
As a whole, qualified annuities are more tax-efficient. And, there’s also “a smaller hit on take-home pay during the person’s working years.”
Unqualified Annuity Taxation
Annuities purchased outside of employee benefits, such as 401(k)s, are non-qualified. Since you’re transferring funds that have already been taxed, you won’t have to pay taxes on your initial investment once it’s disbursed. As a result, you are able to grow your annuity tax-deferred.
There are several examples of nonqualified sourcing funds, such as;
- Savings accounts
- Non-IRA accounts
- Certificates of deposit
- Mutual funds
- Inheritance accounts
Unlike retirement plans like 401(k), there are no contribution limits. Also, there is no mandatory distribution age. Similarly, you can transfer funds between policies through a 1035 exchange with no consequences.
In addition, you can include a death benefit with most annuities. And, a beneficiary or heir can receive the remaining annuity funds if you die before disbursements are issued.
The earnings you receive from your annuity contribution are taxable when you withdraw the money or receive a payout. This includes dividends, interest, and capital gains. Depending on the exclusion ratio, the amount of your withdrawal or payment from investments may be limited.
When you withdraw an annuity, the exclusion ratio refers to the amount that is taxed. Non-qualified annuities are funded with after-tax dollars, so the exclusion ratio is used to figure out what the earnings have been on the annuity since the earnings are not taxable. Withdrawals are subject to taxes, but earnings are permitted to grow tax-free until withdrawal.
What is the Exclusion Ratio?
The insurance company requires an initial lump-sum payment when you purchase an annuity. When you receive payments from your annuity, you won’t have to pay income taxes on a portion of each payment because it is viewed as a return on your principal. Because you paid the principal with after-tax money, the IRS won’t be taxing you again.
However, this is only a portion of what you receive from your insurance company either each month, quarter, or year. Over time, your original principal earns interest, and that money is indeed taxable. In a way, think of this as how taxes work with your additional income streams.
Similarly, gains made within the investment sub-accounts of annuities are taxable. When money is distributed, taxes are deducted from untaxed funds. The monthly exclusion ratio in your insurance contract should be provided to you by your insurance company.
Consider, for instance, an annuity paying out $200 in 20-dollar installments after investing $100. Such an expectation is horribly unrealistic. Nevertheless, it will suffice in helping you better understand the exclusion ratio. In this case, the exclusion ratio would be 50%, which is the ratio of your principal to returns. The first $10 of each check received will not be taxed as you are collecting back your initial investment.
How To Calculate The Taxable Amount Of An Annuity
Again. the IRS acknowledges that you have already paid taxes on the money you use to purchase an income annuity when you do it with after-tax savings. Due to this, when you receive your annuity payments each month, only part of each payment is taxed. This represents the new interest your annuity is generating. The portion of every payment that represents the return of your previously-taxed principal is not taxed a second time.
To compute taxes on your annuity, use the “exclusion ratio” or “pro rata” method, which is based on IRS General Rule 939.
With that being said, the exclusion ratio is one of the reasons why you should consider buying a nonqualified annuity. But, how can you calculate the taxable amount of this annuity?
Percentages are calculated by measuring income tax on periodic payments against the contract’s expected return, explains Shawn Plummer, The Annuity Expert. In order to determine how much of the money received is tax-free as a return of investment in the contract, the percentage is multiplied by the periodic payments. The rest of the periodic payments is taxable as ordinary income.
- Investment Amount ÷ Expected Return = Percentage Of Payment That Is Tax-Free
- 100% – Tax-Free Percentage = Percentage Of Payment That Is Taxable
- $100,000 investment ÷ $150,000 expected return = .6666 (66.7 percent of payment is tax-free)
- 100% – 66.7% (tax-free percentage) = 33.3 percent of payment is taxable
Life expectancy is also taken into account when calculating the exclusion ratio.
A person receiving annuity payments after the age of their actuarial life expectancy is fully taxable if she or he lives longer than expected.
It spreads principal withdrawals over an annuitant’s life expectancy so an exclusion ratio can be calculated. The remaining income payments and withdrawals from the loan are considered earnings once the principal has been accounted for.
So, here’s an example;
- At retirement, you have a life expectancy of 10 years.
- You have an annuity purchased for $50,000 with after-tax money.
- An annual payment of $5,000 – 10 percent of your original investment – is not taxable.
- You live more than 10 years.
- If you receive income in excess of that 10-year life expectancy, it will be taxed.
Annuity Exclusion Ratio Example
Consider the following scenario: You buy a $100,000 immediate annuity at 65 years old.
You are told that you have a 20-year life expectancy and that you will receive $565 a month for the rest of your life from the insurance company. Within those 20 years, you will have grown your initial $100,000 investment to $135,600.
As a result, the insurance company must spread out your $100,000 principal throughout the next 20 years. This would come to just shy of $417 a month. However, you are entitled to $565 a month under your contract.
So, if you used the following formula you the exclusion ratio would be 73.7%
$565 x 240 x = $135,600
Because this is a tax-free return of your original principal, $417 of your $565 monthly payment will not be taxed by the IRS. It’s basically returning to you all of the money you paid them after tax, plus interest.
Because of this, only $148 of your $565 monthly payout will be subject to ordinary income tax.
Since this is the percentage of taxes that are not collected, the exclusion ratio is 73.7 percent. The other 26.3 percent is taxable.
Annuity Withdrawal Taxation
The amount and timing of withdrawals affect your tax bill too.
The taxable portion of your annuity withdrawal may be subject to a 10 percent penalty if you withdraw money before you are 59 ½. The tax on your earnings will be triggered if you withdraw as a lump sum instead of an income stream after that age. On the entire taxable portion of the funds, you will need to pay income taxes that year.
What if you have money remaining in your annuity account? Withdrawals made after the first are considered interest by the IRS and are taxable.
Again, how much of the withdrawal is taxed depends on whether the contract is qualified or not. When you withdraw the full withdrawal amount from a qualified annuity, you will be taxed. Taxes are only due on earnings when it is non-qualified.
Annuity Payout Taxation
As a general rule, each non-qualified annuity income payment has two components according to the General Rule for Pensions and Annuities by the Internal Revenue Service. Your tax-free portion is determined by the net cost of the annuity you purchased. What’s left is the taxable portion.
With an annuity, instead of withdrawing, you receive income payments that are evenly divided over the number of payments expected to be received. In addition to the amount in each payment, the remainder is taxable.
Inherited Annuity Taxation
You must follow the same tax rules if you are the beneficiary of an annuity. Taxation of an inherited annuity is based on the concept that pre-tax dollars are subject to ordinary income tax, while after-tax dollars are exempt.
For annuity owners who want to pass money to their beneficiaries tax-free, life insurance may be a better choice.
Frequently Asked Questions About Annuity Taxation
1. Do you pay tax on annuities?
As soon as you withdraw money or begin receiving annuity payments, you will owe income taxes. You will have to pay income tax on the withdrawal if you bought the annuity with pre-tax money. In that case, you would only pay taxes on the earnings if you bought the annuity with post-tax funds.
If you buy an annuity in the accumulation phase, you can benefit from tax-deferred growth.
2. What type of annuity will cause immediate taxation of interest earned?
There is no way to overstate how important it is to realize that interest earned within an annuity is only taxable when it is withdrawn.
But, the interest earnings on a one-time distribution from an annuity, which is not in a retirement account, are treated as first-in-first-out (LIFO). Generally, you will pay income tax on withdrawals from annuities in non-Roth retirement accounts (self-directed withdrawals or annuity payments).
3. How do I avoid paying taxes on an inherited annuity?
An annuity’s tax burden does not end with the death of its owner. There is, however, the possibility that you can avoid early withdrawal penalties from an inherited annuity if you take distributions before the age of 59 ½.
4. How do I use the General Rule to determine an annuity’s taxation?
Annuity payments or distributions can be excluded from income if you qualify under the General Rule. You can use the IRS’s Publication 939 worksheets to figure out the appropriate amount. You can verify the amount you claim by talking to a tax preparer or CPA.
5. What amount of tax should you withhold from your annuity?
The tax on an annuity is deferred until the income begins to flow. Depending on whether the annuity was purchased with qualified (pre-tax) or nonqualified (post-tax) funds, the income will be taxable. At that time, your tax bracket and total income could influence your withholding strategy.
Article by Albert Costill, Due
About the Author
Albert Costill graduated from Rowan University with a History degree. He has been a senior finance writer for Due since 2015. His financial advice has been featured in Money Magazine, Fool, The Street, Forbes, CNBC and MarketWatch. He loves to give personal finance advice to millennials.