Before you begin taking distributions from an annuity, it's important that you understand the potential income tax consequences that accompany withdrawals. Your age, the type of annuity you own and the manner in which you receive the money will all affect how your money is taxed when you receive it.
Taxes on Annuities Depend on the Type of Annuity and Method of Payment
If your annuity is designated as an individual retirement account, or if it is part of an employer-sponsored group retirement plan, it is categorized as a qualified annuity and your contributions generate an income tax deduction. Any growth within the account accumulates without tax liability until it is withdrawn. Since none of the money in the annuity has been taxed, the full amount of your withdrawal is considered income and subject to ordinary income tax rates.
Individually purchased annuities not designated as IRAs are categorized as non-qualified. Contributions to non-qualified annuities are ineligible for income tax deductions. Earnings accumulate tax-deferred until they are withdrawn, and are included in your taxable income for the year. While non-qualified annuities co-mingle taxed and untaxed money, the entirety of each withdrawal is considered the growth portion and therefore the full amount of every distribution is taxable. Only after annuity payments exceed the annuity's aggregate earnings are subsequent distributions made without income tax liability.
Early Withdrawal Penalties
The IRS requires that money remain within an annuity until you are at least 59 1/2 years old, unless you meet specific criteria for a limited number of exceptions to this rule. In most cases, an annuity withdrawal before 59 1/2 is subject to an early withdrawal penalty of 10 percent on any untaxed portions. Penalties are in addition to the income taxes that would ordinarily be due on those withdrawals.
Annuitization of a Qualified Contract
If you choose to annuitize a qualified contract and convert the entire account balance into a predictable stream of income, every payment you receive is fully taxable and must be included in your earnings for that year. If you annuitize a non-qualified contract, determining the taxable portion of each payment is slightly more complicated because part of each payment is the contract's growth and part is a return of your previously taxed contributions. The IRS refers to this as the "exclusion ratio" and describes in detail in Publication 939 exactly how to determine the taxable portion of non-qualified annuity payments. Subtract your aggregate investment in the annuity from the total balance on the day prior to the first distribution, then divide your actual investment by the number of payments you will receive. Amounts in excess of your calculated investment portion are taxable.
Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.