You're ready to cash in your annuity. You're worried, though, about the taxes you'll have to pay once you turn your annuity into cash. The bad news? You will be taxed on the money that you withdraw from your annuity. But there is an exception that could make your cash-in a tax-free one.
If you withdraw the money from your annuity in one lump sum, you'll have to pay taxes on the difference between the amount that you paid into your annuity and what it's worth when you cash it in. If you paid $150,000 into an annuity that is worth $200,000 when you cash it in, you'll have to pay taxes on the $50,000 in profit that your annuity earned. If you're in the 28 percent income tax bracket, you'll have to pay $14,000 on that $50,000.
The federal government considers gains from annuities to be an example of ordinary income. This is significant because you won't be able to take advantage of the capital gains tax break, which taxes long-term investment gains at 15 percent. Instead, you'll have to pay taxes on your annuity gain that matches your normal tax bracket, even if that bracket is higher than 15 percent.
Other Financial Penalties
Some annuities levy a surrender charge if you cash them out during a certain time period. This charge varies by annuity provider, but it's not unusual to see annuities charge 7 percent of your account's value if you cash out during the first year after you've opened your annuity. Be mindful of this fee before deciding to cash your annuity.
You can avoid paying taxes when cashing out an annuity under one condition: if you transfer your money immediately into another annuity. You do this through what is known as a 1035 exchange. You can use a 1035 exchange if your current annuity is under performing and you'd like to upgrade to one that you feel will experience better gains.
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