Tax on Annuity Interest

by Gregory Gambone

Properly structuring withdrawals from annuities is essential to keeping your financial life efficient and manageable. You must understand the ramifications that distributions will have on your income tax status and the potential liability created by withdrawals. While interest earned in an annuity account is tax-deferred, you will eventually pay the taxes.

Annuities Explained

Annuities are retirement investment accounts created, managed and maintained by life insurance companies. The same IRS rules and regulations regarding contributions and distributions apply as to other types of retirement accounts, but annuities have features not available elsewhere. Money within an annuity remains untaxed until you withdraw it, but the taxable portion of each withdrawal depends on whether your annuity is qualified or non-qualified.

Contributions

Deposits into annuities only generate an income tax deduction if the annuity is held within a qualified retirement plan like an IRA or 401(k). Contributions into qualified accounts are restricted to maximum levels set by the IRS, and those levels depend on your age, income and whether the retirement plan is through your employer or one you arranged on your own. If your annuity is not within a qualified retirement plan, your deposits are not eligible for a deduction, but no maximum limits exist.

Non-Qualified Withdrawals

Since non-qualified annuities contain previously-taxed money and untaxed growth, not all of your withdrawals will increase your taxable income. Only the portions of the distributions considered growth are taxable. The IRS employs the Last-In-First-Out methodology when determining which withdrawals contain growth and which are simply a return of your initial deposits. Using this method, money most recently added to the account is the first withdrawn. This results in fully taxable distributions until the aggregate amount exceeds the growth and begins to contain original principal.

Qualified Withdrawals

Withdrawals from a qualified annuity will increase your taxable earnings for the year. None of the money within a qualified account has been taxed, so the sum total of your distributions for the year are added to your taxable income. For annuities held within qualified accounts, the actual interest earned in your account is irrelevant for tax planning purposes.

Early Withdrawals

If you take a distribution from your annuity before reaching age 59 1/2, you will likely be required to pay an additional penalty tax of 10 percent of the untaxed portion of the withdrawal. Only certain specific situations may exempt your early withdrawal from the penalty, but you will always have to pay the ordinary income taxes. If your early distribution is because you had significant medical expenses, become disabled, payed college tuition or purchased your first house, your situation may be eligible for the penalty exemption.

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.

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