In honor of tax day April 15, which actually happens on April 18 this year, here is some information about annuities and taxes. Kiplinger’s Kimberly Lankford was asked in a recent Q&A “Do I Owe Taxes on Money I Withdraw From My Annuity?“, how a specific annuity would be taxed and offered up helpful information on how annuities in general are taxed by the IRS. In the particular question, the annuity owner purchased a $100,000 annuity which increased in value to $143,000, and then withdrew $120,000 of the money to buy a house. He was wondering how much of his annuity withdrawal would be taxed. Lankford said that it depends on a number of factors, including what kind of account the annuity is in and how the withdrawals are taken.
Your annuity can be in either a taxable account or an IRA. If it is in a taxable account, you have to pay taxes in your top income tax bracket on your earnings. The withdrawal of the first $43,000 would be considered earnings and would be taxable. The rest of the current withdrawal would not be taxed because it is considered a return of the annuity owner’s principal, in this case the remaining $77,000 of the total $120,000 withdrawal. Keep in mind that you are subject to a 10% early withdrawal penalty though if you are younger than age 59 1/2. This penalty is only associated with the earnings amount of your annuity withdrawal in a taxable account. If the rest of your money is left to grow more, the calculations will change with the next withdrawal. The same will hold true though; earnings will be taxed and return of principal will be tax-free.
The calculations are different if your annuity is in a traditional IRA where contributions made were tax-deductible. If that is the case, the entire withdrawal amount is subject to taxes at the highest income tax rate. In addition to that, the entire amount is also subject to the 10% early withdrawal penalty if the annuity owner is not yet 59 1/2.
It’s important to consider how you will take your money out of your annuity, especially in a taxable account. Instead of taking a large withdrawal, consider converting your annuity into an income stream that will pay either over a specified period of time or for the rest of your life. By annuitizing your account, a portion of the payouts are a tax-free return of principal and the rest will be considered earnings. This amount is based upon how long you will be receiving payments. A life annuity will pay income payouts until you die, so life expectancy tables from the IRS are used to determine the age that you are expected to die. You can divide your annuity contributions by that number to figure out how much of your payout is a tax-free return of your principal. Then you will know that you’ll only be taxed on the remaining amount of your payout.
The taxes related to annuity products can sometimes be confusing. It’s often wise to speak with an annuity tax expert if you have made large withdrawals or started receiving annuity income payouts for the first time in any given year. It’s better to be safe than sorry when filing your taxes and determining how much of your annuity income is taxable.
Written by Rachel Summit