Tax Implications for When an IRA Is Converted to an Annuity
Original post by Cindy Quarters of Demand Media
An individual retirement account (IRA) can be converted to an annuity by the account owner in order to provide a steady stream of income at a consistent interest rate. An annuity is a contract that provides the owner with substantially equal payments on a regular basis. The amount of the payments, the number of years the payments will last and the frequency of the payments are all defined in the annuity contract. There are usually no tax consquences when changing from an IRA to an annuity.
If the IRA funds are directly converted to an annuity, there are no taxes due. This only applies to funds that are directly transferred between trustees, such as a bank and the insurance company providing the annuity. If the IRA trustee issues a check to the account holder, a flat 20 percent tax withholding applies. An additional 10 percent will be withheld if the account owner is under 59 1/2 at the time of the transfer. Withholding is avoided with a trustee to trustee transfer of funds.
Types of Annuities
Annuities can be fixed, variable or indexed. The type of annuity usually affects the amount received by the owner, which in turn can affect the taxes she owes. A fixed annuity is one that promises a specific interest rate and guarantees a minimum payment amount, either for a defined number of years or a period of time such as the account owner’s lifetime. A variable annuity allows the account owner to choose among various investment options, and the money paid out depends on how those investments perform. An indexed annuity is linked to the performance of a market index and increases according to the performance of the index chosen. Indexed annuities typically guarantee a minimum return.
When a traditional IRA begins to pay out funds to the account owner, the money is taxed as regular income in the year in which it is received. There are no penalties or withholdings required above what the owner specifies. IRA income is reported with all other income and deductions the owner has and is reported on a Form 1040. Early withdrawal may cause substantial tax penalties, depending on the circumstances.
When the owner of an annuity begins receiving regular payments from an annuity, these are taxed in the same manner as funds received from an IRA or any other tax-deferred retirement account. The money received is considered regular income and is reported as part of the recipient’s regular tax reporting, using Form 1040. An early withdrawal from an annuity may not only trigger tax penalties, but is also likely to cause significant penalties from the insurance company holding the annuity contract.
- U.S. Securities and Exchange Commission: Annuities
- IRS:gov: Individual Retirement Arrangements (IRAs)
- Immediate Annuities: Take Advantage of the Tax-Free Rollover Rules to Move Your IRA or 401k Into an Annuity
About the Author
Cindy Quarters has been writing professionally since 1984, creating both user manuals and training documentation. She also writes travel, pet and gardening articles, with work published in "Radiance Magazine" and the "AKC Gazette." Quarters earned a Bachelor of Arts in English from Washington State University, as well as a master's degree in management information systems from West Coast University.