Annuities are tax-advantaged retirement investment products offered by life insurance companies. Money within annuities grows tax-deferred until it is withdrawn. These products offer potentially significant opportunities for investors to accumulate money for use during retirement. Withdrawals from annuities are always taxable, regardless of the type of annuity or the time the withdrawal is made. However, different scenarios and situations may result in different taxable amounts, including the presence of penalties or mandatory distributions.
Qualified vs. Non-Qualified
Determining how much of your annuity withdrawal is taxable depends on whether the annuity account is qualified or non-qualified. Qualified annuity deposits generate an income tax deduction and IRS limitations exist on the total you may contribute each year. Non-qualified annuity deposits do not result in deductions and no restrictions exist on how much money may be contributed.
Qualified Annuity Withdrawals
Withdrawals from annuities that occur after you reach the IRS designated age of 59 1/2 result in an increase to your taxable income for the entire amount of the distributions. Since the money originally deposited into a qualified annuity resulted in an income tax deduction, the entire value of the annuity account is subject to ordinary income taxes when it is withdrawn. The aggregate sum of qualified annuity withdrawals increases your taxable earnings, and large enough amounts may raise your income to a higher tax bracket.
Non-Qualified Annuity Withdrawals
Withdrawals from non-qualified annuities increase your taxable income for the year, but only for the portions of the distributions deemed growth, as opposed to a refund of your deposits. The IRS utilizes the Last-In-First-Out (LIFO) method when considering non-qualified annuity withdrawals, which states that the money most recently deposited into the account is the first to be withdrawn. This results in fully taxable distributions until the aggregate withdrawals exceed the growth and begin to include original principal.
When you reach age 70 1/2, you must begin taking withdrawals from your annuities that are equal to or greater than the minimums established by the IRS. These mandatory withdrawals, called Required Minimum Distributions (RMD's), are imposed by the IRS to ensure they eventually receive the taxes due on the money you saved. RMD calculations consider your age, life expectancy, and the total value of your account. You must withdrawal at least the required minimum each year, or face additional penalties.
Any withdrawals made from annuities before you reach age 59 1/2 may be subject to an additional penalty tax of ten percent. This penalty is in addition to the ordinary income taxes due on the amounts withdrawn. Some exceptions exist to the early withdrawal penalty rule, which may allow you to avoid the ten percent penalty, but not the ordinary income taxes. Exceptions to the penalty include extreme medical expenses, college tuition payments, disability or the purchase of your first home.
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