Are Annuity Payments Taxable?

Annuities are a great way to build your nest egg while also deferring tax payments. You can allow money to compound every year and choose how you want your annuity payments paid out.

However, the tax situation can be a bit confusing. Many people wonder, “are annuity payments taxable?” Let’s take a look at the factors that determine whether your annuity payments are taxable.

What Is an Annuity Payment?

When you buy an annuity, the insurance company that you entered the contract with is required to make payments to you. You can buy the annuity in either a single payment or a series of payments.

The annuity payments may happen either immediately or in the future. They can also be either a lump-sum annuity payment or a series of payments. You can also sell annuity payments for cash.

Are Annuity Payments Taxable?

Annuities offer the advantage of being tax-deferred. They allow investments to grow tax-free until withdrawn. This means dividends, interest, and capital gains are eligible for tax-free reinvestment while still in the annuity. 

In general, annuities are taxable when you receive income payments. Withdrawals and lump-sum distributions are not taxed as capital gains, as some other investments are. However, several rules dictate which funds are taxed, how, and when. 

The specific rules can get quite confusing for the average investor. The biggest difference for most investors is how the annuity was set up. Right Way Funding can help walk you through these rules.

Qualified Annuities

If you fund an annuity with money that has not had taxes paid, it is a qualified annuity. Usually, these annuities receive funds through 401(k)s or tax-deferred retirement accounts like IRAs.

Payments from qualified annuities are taxable as income. This is because no taxes have been previously paid on the money. You’ll need to report the entire amount in the tax year that you receive it.

Annuities purchased with money from ROTH IRA or ROTH 401(k) accounts may be tax-free if you meet certain requirements.

Non-Qualified Annuities

Non-qualified annuities are purchased with money that is already reported to the IRS and taxed. Lottery annuity payments are a common example.

For these kinds of annuities, you pay taxes on the earnings based on the exclusion ratio. This ratio determines how much is taxable earnings vs. after-tax principal.

The exclusion ratio takes into account the principal used to purchase the annuity, how long the annuity has existed, its interest earnings, as well as the annuitant’s life expectancy. This is because annuities should be spread over the rest of the annuitant’s life.

Other Tax Implications

Sometimes people withdraw money from their annuity before age 59 ½. If you do this, you may need to pay a 10 percent penalty based on the taxable portion of the withdrawal. 

Sometimes, you may be a beneficiary who inherits an annuity. If this is the case, the same tax rules apply. Any after-tax money used towards the principal is not subject to income taxation. This amount is the exclusion amount.

Annuity Payments and Taxes

Annuities can be a great way to save money and let your earnings grow. However, it can be confusing to know, “are annuity payments taxable?” Taking the time to understand your unique annuity setup can help you determine if your annuity payments are taxable or not.

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