How Are Annuities Taxed?
Question: How are annuities taxed? from Darrell in Phoenix, AZ
Answer: That’s a pretty broad question Darrell, but and extremely important one. Let me get right to the point when it comes to annuities and taxes. Always use a CPA or qualified tax professional for any type of tax questions that are related to annuities. Never take an agent’s word for it. I probably know more about annuities and taxes than most (heck, I’m Stan The Annuity Man!), but even I defer all questions to the tax pros. I’m an annuity pro, not a tax pro. With that being said, and with the hope that you fully understand that a tax pro will have to eventually sign off on any tax recommendation, let’s look at some broad tax issues concerning annuities.
Even though annuities are classified as life insurance products, annuity death benefits are not taxed the same as life insurance. The death benefit proceeds from a life insurance policy are free from taxes, and also avoid probate. Death benefits from annuities do NOT pass tax free to the beneficiaries.
Income from Annuities
Annuity income is taxed at ordinary income levels, and from a LIFO (Last In First Out) accounting method. In English, that means that the gains come out first, and you are taxed on those gains first. Just like money taken from your IRA is taxed at ordinary income levels, so is any income stream from annuities.
If an income stream is “annuitized”, than means the income is generated from a combination of a return of principal and interest. If the income is not coming from an IRA, then there is an “exclusion ratio” involved. Exclusion ratio simply means that you will not pay taxes on the return of principal (makes common sense), just the interest part of the income. Annuitized income coming from an IRA has no exclusion ratio, and the entire income stream is taxable at ordinary income levels.
Free Withdrawals from Annuities
Most deferred annuities allow you to take 10% per year (penalty free) from your annuity from a liquidity standpoint. Any money withdrawn from an annuity is brought out “gains first”, or LIFO. Understand that you will pay taxes at ordinary income levels on all of the gains (if any) before you start dipping into the principal. Once the gains are depleted, and you start withdrawing principal, there will be no taxes on that original principal amount.
There are books written on the subject of annuities and taxes. My favorite is written by John Olsen, called “Taxation and Suitability of Annuities.” He covers all of the bases of annuity taxes with trusts, estate planning, etc., and it really should be required reading for all agents as a foundation of knowledge only…..and not license to give tax advice in any circumstance.
The bottom line is that with anything tax related concerning annuities, it can get complicated…..and you cannot afford to make mistakes with our “friends” at the IRS. Don’t let an annuity agent tell you otherwise, and don’t depend solely on an agent for tax advice. Always use a tax professional.
*If you have a question for Stan The Annuity Man, please send your question to firstname.lastname@example.org. He will answer all questions directly, and might include yours in his next Annuity123 “Ask Stan The Annuity Man” blog every Thursday.
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Stan, Nice job! I would add a couple of caveats. If you want the owner and annuitant to be different parties (and that's usually a bad idea), confirm is your deferred annuity is "annuitant-driven". If so, you may be surprised at "whose death triggers which death benefit". Also, don't name a trust as owner OR beneficiary of your deferred annuity unless you KNOW the tax implications and are happy with them.