How to Treat Income From Annuities

By | February 26, 2014

How is Income from annuities treated for taxes?

Annuity contracts generally require the purchaser to pay a fixed amount for the right to receive a future stream of payments for a specified number of years or life  No income is recognized by the annuitant at the time the cash value of the annuity increases because the taxpayer has not actually received any income.A deferred annuity has two phases, the accumulation phase and the distribution phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. In the distribution phase, the annuity is paid out.


What is an Annuity Premium?

The money that you put in an annuity is referred to as a premium, it’s your original contribution or principal contribution. Since you already have paid taxes on it, it never again will be subject to taxation.


How to Treat Income From Annuities

When you withdraw money from your annuity the earnings, according to the IRS, are withdrawn first. The “earnings” are subject to “ordinary income taxes” in they year in which they are withdrawn. Keep in mind that capital gain distributions in a mutual fund are taxed at capital gains rates. This can be important for tax planning in retirement.


There are no penalties on Annuity distributions:

  • Made after your 59 1/2.
  • Made on or after the death of the owner of the annuity.
  • If the taxpayer becomes disabled.
  • A part of a series of substantially equal periodic payments (not less than annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.
  • Made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.
  • Made under certain annuities issued in connection with a structured settlement agreements.

The exclusion ratio (investment ÷ expected return) applies to annuities until the annuitant has recovered all of their investment. Once the investment is completely recovered, the entire amount of subsequent payments made is taxable. If the annuitant dies before recovering the investment in the annuity, the unrecovered cost is tax deductible in the year the payments cease.

Overall, the tax rules for annuities are tax payer favorable and can make annuities a vital part of retirement planning.


Medicare Tax on Investment Income

Beginning in 2013, distributions from non-qualified annuity contracts, to the extent not excludible from income, will generally be subject to the 3.8% Medicare tax on investment income for taxpayers with adjusted gross income (with certain modifications) over $250,000 in the case of married couples filing jointly and qualifying widow(er)s with dependent children, $125,000 in the case of married taxpayers filing separately, or $200,000 in the case of other taxpayers.


Tax Free 1035 Exchanges for Annuities

There are some other favorable tax code sections for annuities. Section 1035 of the U.S. tax code allows the owner of an annuity to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in the current variable annuity account. This would allow the owner of an annuity to switch the annuity product that they are currently in.  This is like rolling an IRA or 401k into another IRA.  Section 1035 tax-free exchanges are permitted for life insurance policies as well as annuities. A savvy investor who wants to switch because of high fees or bad service can avoid owing tax on the exchange by utilizing a Section 1035 annuity exchange.