If you have a retirement plan at work or your own IRA, you probably have a good idea of how these qualified annuities are taxed once you begin making withdrawals. Non-qualified annuity taxation is somewhat different and is calculated based on investment income.
Qualified vs. Non-Qualified Annuity
Qualified annuities are funded with pre-tax dollars and can qualify as a tax deduction. Non-qualified annuities, on the other hand, are funded with post-tax dollars, meaning money you've already paid tax on. Non-qualified variable annuities grow but aren’t taxed until funds are removed from the account. This occurs either because the annuity’s owner makes a withdrawal, or because of annuitization, the process of converting the non-qualified annuity into regular income payments. How much of the annuitization is taxable is determined by when the policy is annuitized. Your insurance company calculates an exclusion ratio at that time, which determines what percentage of the payments are not subject to income tax. Non-qualified annuities primarily consist of principal return, and that amount is not subject to tax. The investment income from non-qualified annuities is taxed as ordinary income, not as capital gains. In this sense, the investment income is similar to the taxation of 401(k)s, non-Roth IRAs and other qualified retirement plans.
Annuity Beneficiary Taxation
If the beneficiary of a non-qualified annuity is anyone other than a spouse, deferred earnings are taxed as ordinary income. There is no step-up in the cost basis at death. If the beneficiary is a spouse, they may continue the variable annuity policy and the tax-deferred growth. When it comes to estate taxation, non-qualified annuities are counted as assets for tax purposes.
2018 Non-Qualified Annuity Taxation
The Tax Cuts and Jobs Act, signed into law on Dec. 22, 2017, does not change non-qualified annuity taxation per se, but it does change the federal tax brackets, so recipients of non-qualified annuity income may find less of it subject to taxation or they may not have to pay taxes at all. The new tax brackets are 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent. The federal estate tax exemption is $5.6 million per person and $11.2 million for married couples.
2017 Non-Qualified Annuity Taxation
For 2017, the tax brackets on ordinary income are 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent. The federal estate tax exemption is $5.49 million for individuals and $10.98 million for married couples.
- IRS: Is My Pension or Annuity Payment Taxable?
- IRS: Publication 575 (2017), Pension and Annuity Income
- Investopedia: How are non-qualified variable annuities taxed?
- Insured Retirement Institute: Taxation of Annuities
- Investopedia: Qualified Annuity
- Tax Foundation: Income Tax Brackets and Rates
- Tax Foundation: 2017 Tax Brackets
- Form 1040 Tax Forms image by Viola Joyner from Fotolia.com