Question: I purchased an annuity several years ago, and I'd like to start receiving payments from it. How can I figure out what the tax treatment will be?
Answer: The key first step in answering this question is to determine what type of annuity you have. If you purchased the annuity through your employer, it's a good bet that it's a qualified annuity. But if you bought the annuity on your own, it's probably a nonqualified annuity.
These two annuity types differ in tax treatment, both at the time you contribute as well as when you begin taking out money. From a tax standpoint, a qualified annuity is similar to a traditional 401(k). You're able to contribute pretax dollars, and your money compounds on a tax-deferred basis, meaning you won't pay any tax on investment gains from year to year until you withdraw your money. But as with traditional 401(k) withdrawals during retirement, you'll owe tax on both your initial contributions and any investment gains when it comes time to draw income from the qualified annuity.
By contrast, a nonqualified annuity is one held outside of an IRA or qualified retirement plan. You contribute aftertax dollars to a nonqualified annuity, and this is true whether the annuity is immediate or deferred, fixed or variable. Your money compounds on a tax-deferred basis, just as is the case with a qualified annuity. The only time you'll owe taxes is when you begin taking money out during retirement. At that point, the tax treatment will depend on how you go about withdrawing money.
Withdrawing From a Nonqualified Annuity
If you simply take withdrawals from your nonqualified annuity during retirement, the Internal Revenue Code assumes that your investment gains come out first, and you'll owe ordinary income tax on those first distributions. Once you've withdrawn the entire investment-earnings component of your annuity balance, you'll be taking out the money you put into the annuity in the first place. That amount--called your basis--is tax-free when you withdraw it, as it should be, because you already paid tax on that money. For example, say you put $200,000 into an annuity that eventually grows to $275,000. If you withdraw $100,000 from the annuity, you'll owe tax on $75,000, the amount of your investment earnings, but the additional $25,000 will be tax-free. (Withdrawals from annuities purchased prior to Aug. 14, 1982, receive different tax treatment; check with a tax advisor for details if this applies to you.)
The other method of getting money out of a nonqualified annuity is to annuitize--essentially, to turn your annuity into a stream of income. Taxation after annuitization is different from outright withdrawals from an annuity. In that case, each annuity payment you received is taxed partially, based on the ratio of basis (that is, the money you originally put in) to earnings in each payment.
For example, say you put $100,000 into a nonqualified annuity. When you annuitize, the insurer agrees to pay you $1,200 a month for the next 10 years. In that case, roughly 69%, or $828, of each payment will be tax-free, with the rest taxable at your ordinary income tax rate. That percentage, called an exclusion ratio, is arrived at by dividing the amount you put into the annuity--$100,000--by the total amount you'll get out--$144,000 ($1,200 a month times 120 months).
If you are receiving annuity payments for the rest of your life, the total value of your nonqualified annuity payments is determined by multiplying your annual payment amount by your life expectancy. For example, if your life expectancy at the time of annuitization is 17.5 years and you were receiving $1,200 a month, your total payment is $252,000. Assuming you originally put $200,000 into the annuity, roughly 79% of each payment would be excludible from taxes. ($200,000 divided by $252,000 is 0.79.)
Bear in mind that the above tax examples relate to annuity payments and withdrawals after age 59 1/2. If you withdraw before that age, your distributions would receive the same tax treatment outlined above, but you'd also owe an additional 10% early-withdrawal penalty on the taxable portion of your withdrawals, unless you meet certain other criteria.
A version of this article appeared Dec. 13, 2012.
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