If you already own an annuity or are considering purchasing one, you must become familiar with the potential income tax ramifications of money flowing into and out of these investment vehicles. Depending on the specific type of annuity, and the account within which is it held, certain income tax advantages may or may not be available.
Money deposited into qualified annuities generates an income tax deduction. Any growth within the account will accumulate without tax liability until you withdraw it. Because the IRS permits tax deductions for contributions to qualified plans, restrictions have been placed on the total amount you may deposit each year. Contribution maximums differ from one retirement plan type to the next.
Money deposited into non-qualified annuities does not result in an income tax deduction. However, any growth within the account accumulates without liability until it is withdrawn. Non-qualified annuities are a combination of previously taxed money and untaxed money. Because you've already paid income taxes on the dollars used to fund a non-qualified annuity, no IRS restrictions exist on how much you may contribute.
To avoid additional taxes and penalties, the IRS requires you to leave money within annuities until you reach age 59-1/2. Once you achieve this designated retirement age, you may freely withdraw money from your annuity without penalty. However, the untaxed portion of your withdrawals will increase your taxable earnings for the year. If your annuity is a qualified account, the entire sum total of your distributions will be taxable. However, if your annuity is non-qualified, only the portions deemed growth will be added to your taxable income for the year. The IRS uses the last-in first-out, or LIFO, methodology, which states that the money most recently added to the account is also the first withdrawn. This results in entirely taxable distributions until the aggregate withdrawals exceed the growth.
If you choose to withdraw money from an annuity prior to age 59-1/2, you will be charged a penalty tax of 10 percent of the previously untaxed portions. Taking early distributions from a qualified annuity generates a penalty of 10 percent on the entire amount withdrawn. Conversely, early distributions from a non-qualified annuity only create penalties for the untaxed growth you receive. The remainder of the withdrawals are considered a return of your deposits.
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