How to Avoid Paying Taxes on Your Annuity (2024)

An annuity is an insurance company product that sometimes appeals to investors who are risk-averse or who have contributed the maximum to their retirement accounts. One advantage of an annuity is that there is no maximum contribution like 401(k)s or individual retirement accounts (IRAs) have. The earnings from an annuity also grow tax-deferred. If you’re thinking about using an annuity in retirement or just to generate extra income, you may want to work with a financial advisor first. SmartAsset’s free financial advisor matching tool can match you with advisors who serve your area.

Annuities and Taxation

Purchasing an annuity is a tax-deferred way of increasing your retirement savings. It is a contract between you and an insurance company that will pay you regular payments either beginning at purchase or at some point in the future. Purchasing an annuity is a way to increase and protect your retirement savings.

There is no limit on how much you can contribute to an annuity unlike a 401(k) or an individual retirement account (IRA). Annuities have the same early withdrawal taxation rules as other retirement accounts. If you make a withdrawal, you will be subject to taxes and a 10% early withdrawal penalty.

One of the advantages of buying an annuity is that the earnings are allowed to grow on a tax-deferred basis until withdrawal. Earnings include interest, dividends and capital gains. The earnings are reinvested each year without any tax impact. However, there are disadvantages including the rate at which you’re taxed. One factor that determines the taxation of annuities is whether you have a qualifying or non-qualifying annuity.

Taxation on Qualified Annuities

How annuities are taxed depends on whether your account is a qualified or a non-qualified account. A qualified annuity has been purchased with pre-tax dollars. If you use the money from a 401(k), 403(b), traditional IRA, SEP-IRA or SIMPLE IRA to purchase an annuity, it will be classified as a qualified annuity since those are all funded with pre-tax dollars.

The payments from this type of annuity are fully taxable as ordinary income but not until you make a withdrawal or start receiving payments. If you make an early withdrawal, you may have to pay your full contribution to the annuity plus the 10% penalty.

Taxation on Non-Qualified Annuities

Non-qualified annuities are funded with after-tax dollars. If you buy your annuity using money from a regular savings or money market account or a taxable brokerage account, you do not have to pay taxes on withdrawals or periodic payments from your principal amount since a non-qualified annuity is funded with after-tax dollars.

You do have to pay taxes on the earnings of your contribution to the annuity when you make a withdrawal or receive a payout. Earnings are dividends, interest and capital gains. The amount of your withdrawal or payment from investments is subject to the exclusion ratio. The exclusion ratio refers to the portion of your contribution to an annuity that is taxed upon withdrawal.

Since a non-qualified annuity is funded with after-tax dollars, the purpose of the exclusion ratio is to determine what the earnings have been on the annuity since they have not been taxed. Taxes have to be paid upon withdrawal, but earnings are allowed to grow tax-free until withdrawal.

If you own a nonqualified variable rate annuity, you have a tax advantage over other nonqualified accounts like mutual funds or brokerage accounts. If you have investments in those types of accounts, you pay taxes on the capital gains distributions, interest and dividends that you receive at the end of every tax year.

In contrast, the nonqualified variable rate annuity does not have any tax liability until you start making withdrawals or taking payouts. Bear in mind that your earnings, when they are withdrawn, are taxed at the ordinary income tax rate not the more favorable capital gains tax rate. Another disadvantage is there is no opportunity for Roth conversions.

Taxation of Other Classifications of Annuities

There are also immediate and deferred annuities and fixed and variable annuities, each with its own way of functioning.

Other Types of Annuity Taxation

If you inherit an annuity, the same tax rules apply if you are the spouse of the annuitant. You can choose to receive your payouts according to the annuity schedule. In that case, taxes are deferred until you make withdrawals or receive your payouts. If you are not the spouse of the annuitant, the tax status depends on your choice of how to receive your payouts.

If there is a balance in an annuity when the owner dies, there is a tax obligation. Tax is calculated based on the difference between the premiums paid into the annuity and the balance left in the annuity at the annuitant’s death. If there is a death benefit associated with the annuity, it is generally treated as taxable income, unlike life insurance.

To avoid paying taxes on your annuity, you may want to consider a Roth 401(k) or a Roth IRA as a funding source. Then, you do not pay taxes upon withdrawal since Roth accounts are funded with after-tax dollars.

Bottom Line

As you consider whether an annuity makes sense for you, it’s important to remember that the advantage of an annuity is that earnings grow tax-free until withdrawal. However, you pay for that advantage by taxation at the higher ordinary income rate when you do make a withdrawal and a lower return on your investment. For very risk-averse investors, annuities may be an option because, in some cases, your principal is protected. Another advantage of annuities is that there is no maximum retirement contribution. This makes them an extra investment possibility after you max out your retirement accounts.

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