An annuity is an insurance product that pays income. The product is purchased with a lump sum of money or through a series of payments. When you retire, the investment is converted into a stream of income. If you take distributions before age 59 1/2, you will face a 10 percent tax penalty in addition to ordinary income taxes. Annuity income is taxable when you begin taking withdrawals. The type of annuity you have determines how much of the distribution is taxable.
A qualified annuity is one that you fund with pretax money. These annuities are often set up by employers as part of a retirement plan offered to employees. Qualified annuities are taxed the same as any other tax-advantaged account such as an individual retirement account or 401(k). Although your investment is earning interest, you do not report the earnings until you begin receiving payments. The entire payment you receive is considered taxable income.
You can rollover a qualified annuity to another qualified account to maintain the tax-deferred status. For example, you can roll traditional IRA funds into an annuity or your annuity into an IRA without paying taxes on the transaction. The same tax rules apply for funds you roll over into another qualified investment. If you are in a taxable income bracket, you are required to pay income taxes on any voluntary or mandatory distributions.
A nonqualified annuity grows tax-deferred until you begin taking withdrawals. Since the annuity is funded with after-tax dollars, your distributions are partially taxable. Only the interest earnings are taxable at ordinary income tax rates at the time of withdrawal. If you decide to just take out the principal, you do not pay taxes.
You cannot withdraw the interest from a nonqualified annuity until you reach age 59 1/2. Unlike a qualified annuity, you are not required to take mandatory distributions when you reach age 70 1/2. You can withdraw from the annuity as needed or keep the money in the annuity to defer taxes until a later date. One of the main benefits of a nonqualified annuity is the ability to reinvest your interest gains. The reinvested gains grow tax-deferred, allowing you to benefit from compounding interest. The taxable income continues to grow tax-deferred for as long as you wish.