Tax-Deferred Annuity Taxation Rules
Original post by Gregory Gambone of Demand Media
Annuities are retirement investment vehicles owned and managed by life insurance companies. Multiple types of annuities exist, each with its own set of features and benefits. Money deposited into annuities grows without tax liability until it is actually withdrawn. IRS regulations stipulate that money within an annuity must remain until the owner reaches age 59-1/2, otherwise penalties may be imposed for early withdrawals. If you own an annuity, or are considering an investment into one, you must familiarize yourself with the tax treatment of these products.
Contributions into Qualified Annuities
Qualified annuities are held within employer-sponsored retirement plans such as 401k's or 403b's, or within an individual retirement account. Contributions into these accounts are limited to specific amounts defined by the IRS. Deposits result in an income tax deduction for the aggregate amount of your contributions.
Contributions into Non-Qualified Annuities
Non-qualified annuities are purchased privately outside an employer's plan or an IRA. Income tax deductions are not permitted for money deposited into non-qualified annuities, therefore the IRS imposes no limits or restrictions on how much may be contributed. However, some annuity carriers may place their own internal restrictions on deposit amounts exceeding $1 milion.
Withdrawals from Qualified Annuities
IRS regulations restrict withdrawals from qualified annuities until you reach age 59-1/2. When you reach the designated retirement age and begin taking distributions, the entire amount of the withdrawals is added to your taxable earnings for the year. Since no taxes have been paid on any of the money within the account, the entire aggregate distributions are taxable as ordinary income.
Withdrawals from Non-Qualified Annuities
While IRS regulations regarding distributions from retirement accounts also apply to non-qualified annuities, only the portions of your withdrawals considered growth, as opposed to a return of your deposits, are added to your taxable earnings for the year. However, to determine whether a distribution is growth or a return of contributions, the IRS uses the last-in-first-out methodology, which stipulates that money most recently added to an account is withdrawn first. Therefore, every distribution will be entirely taxable until aggregate withdrawals exceed all of the growth and begin to include initial principal.
Early Withdrawal Penalties
Regardless of whether your annuity is qualified or non-qualified, any taxable withdrawals occurring before you reach age 59-1/2 may incur penalties. The early withdrawal penalty is an additional tax of 10 percent of the previously untaxed portion of the distribution. If you withdraw money early from a qualified annuity, the entire distribution amount will be subject to the penalty. If you withdraw money early from a non-qualified annuity, the portion deemed growth will be subject to the penalty.
Exceptions to Early Withdrawal Rules
Certain specific situations or events may qualify you for an exemption to the 10 percent early withdrawal penalty. The IRS describes these exceptions in Publication 590, and explains that while the penalty may be waived, the distributions still increase your taxable earnings for that year. Exceptions to the early withdrawal penalty include excessive medical expenses, disability, college tuition and the purchase of your first home.
Death Benefit Payouts
When an annuity owner dies, the balance within the account is transferred to the named beneficiary. The proceeds are added to the beneficiary's taxable earnings for the year, regardless of whether the annuity was qualified or non-qualified. Beneficiaries usually have the option of taking the proceeds as a single lump sum, which would result in potentially significant tax liability, or as a stream of payments spread over several years, which would reduce the taxes owed to only the amounts distributed each year.
- Internal Revenue Service: Publication 575 -- Pension & Annuity Income
- Getting Your Financial Ducks in a Row; Exceptions to the IRA Early Withdrawal Penalty; September 2010
- Edward Jones: Annuity Taxation
- ImmediateAnnuities.com: Non-Qualified Annuity Tax Rules
- Senior Market Advisor; Annuity Taxation Primer; David Port; March 2008
About the Author
Gregory Gambone is Senior Vice President of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.