Taxes on annuities can feel complicated, but the basics are easier to understand once you break them down. Annuities are contracts that can provide guaranteed income, but how that income is taxed depends on the type of annuity you own and where it’s held.
Two Main Categories of Annuities
When it comes to income, annuities generally fall into two categories:
- Annuitized contracts – These include Single Premium Immediate Annuities (SPIAs), Deferred Income Annuities (DIAs), and Qualified Longevity Annuity Contracts (QLACs). Once you start payments, the money flows regularly, much like a pension.
- Deferred contracts with income riders – These are add-ons to products like Indexed or Variable Annuities. Instead of fully annuitizing, you withdraw income over time based on rider guarantees.
How Annuitized Products Are Taxed
For SPIAs, DIAs, and QLACs, payments are made up of both principal and interest. The way they’re taxed depends on the account type:
- Non-qualified accounts (funded with after-tax dollars): You’ll only owe tax on the interest portion of each payment. Once all principal has been returned, the remaining income is fully taxable.
- Qualified accounts (IRAs and other tax-deferred plans): Since contributions were made pre-tax, every dollar of income is taxed as ordinary income.
Tax Rules for Income Riders
With income riders, the taxation works differently. Withdrawals follow the Last In, First Out (LIFO) method, meaning the earnings come out first. You’ll pay taxes on those gains before touching your principal. Once the account value hits zero, the insurance company continues payments, but at that point, the income is entirely taxable.
The Role of Tax Brackets
The actual amount you owe depends on your tax bracket. Annuity income is taxed as ordinary income, not capital gains, so your marginal rate applies. The insurance company will also issue a 1099 each year, which you’ll need when filing taxes.
Why Professional Advice Matters
It’s important to remember that while annuities can provide reliable income, their tax treatment isn’t one-size-fits-all. Rules differ depending on the product, account type, and your personal situation. That’s why it’s best to review your specific case with a qualified CPA or tax attorney before making decisions.
Final Thoughts
Annuities can be a powerful tool for retirement income, but understanding how the IRS views those payments is essential. By knowing the basics of how annuitized contracts and income riders are taxed, you’ll be better prepared to plan ahead and avoid surprises at tax time. Always confirm your strategy with a tax professional so your retirement income works as efficiently as possible.
