In “How Annuity Withdrawals are Taxed” by Kimberly Lankford of Kiplinger’s Personal Finance, Lankford explains the ins and outs of taxes on annuities. There are 3 things that need considering when determining the taxes for annuities: whether it is an immediate or deferred annuity, with what money the annuity was purchased and in what way you will receive the payouts.
Immediate annuities take a lump sum payment from you to an insurance company and release monthly payouts to you for the remainder of your life. When using either an IRA or 401(k) that has yet to be taxed, your payouts will be subject to your normal income tax rate. If you have purchased the annuity with after-tax money, then you will only be taxed on any payouts above and beyond your initial investment. Immediate annuities in which you receive payments for life use the IRS’s life expectancy for people your age to determine your payment period. They use that number to figure out how much of your investment is a tax-free return and how much is subject to taxes.
With deferred annuities, you put money either in a lump sum or over time with the plan to receive monthly payouts at a fixed time in the future. Whether your annuity is variable or fixed, it grows tax-deferred until you begin getting your payments. You can usually make transfers between funds in a variable annuity or even between different deferred annuity options without being taxed. Once you begin your withdrawals the taxes are like with immediate annuities, based on whether you used pre-tax or after-tax dollars to purchase the deferred annuity. If you withdraw all of the money at once you will be taxed on any gains above your original investment. With smaller withdrawals over time, all gains come out first and are taxed accordingly until you get to the original investment amount. You can also annuitize the deferred annuity, which would allow you to take payment over your lifetime like with an immediate annuity. That option would follow the same tax rules as the latter.