An annuity contract guarantees a stream of monthly payments for a fixed term or for life. In a variable annuity, the earnings in the account will vary according to the success of the investments the account holds. When you take distributions, the IRS requires you to report those earnings and pay taxes unless the annuity is part of certain tax-sheltered "qualified" plans.
The IRS defines an annuity as a contract that pays you in regular installments over a period longer than a year. This covers fixed as well as variable annuities. You can purchase an annuity on your own or through an employer-sponsored plan. If the annuity is part of a qualified plan, such as an individual retirement arrangement, the contributions you make to it are tax-deductible and the earnings it generates are tax-free until you take distributions.
If you simply withdraw money from an annuity, and don't take a distribution according to the contract terms, the amount you withdraw is considered earnings and is taxable; any amount over and above earnings is considered part of your original cost and is tax-free. The IRS does not allow you to use the capital gains rate on the income. This means that you pay taxes on the withdrawal at your ordinary income tax rate, which varies with your net taxable income. The higher your net, the higher the tax rate, which varied from 10 percent to 39.6 percent as of 2013. The IRS will also penalize you 10 percent if you haven't reached the standard retirement age of 59 1/2.
Taking a regular distribution according to the contract terms is known as "annuitizing." The IRS "General Rule" allows you to exclude from taxes a percentage of the payouts. The amount is based on the ratio of your cost to the expected total return on the annuity, which in turn is based on an IRS life-expectancy table. You also must use the General Rule if the payments start after you reach 75 and are guaranteed for at least five years.
Roths and Non-Roths
If your annuity is part of a qualified plan, the IRS treats it according to the rules governing distributions and account types. In a Roth, the entire distribution is tax-free if the funds have been in the account for at least five years and you have reached 59 1/2. For non-Roth plans, the IRS requires the "Simplified Rule." You must divide the original cost of the annuity by the number of months you expect to receive distributions based on your age and an IRS table. If you invested $200,000 and expect distributions over 20 years, you divide $200,000 by 240 to arrive at $833.33 -- this amount represents your original cost and is not subject to income tax. Any distribution over and above it is taxable -- again at the ordinary income tax rate.
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