How Do Taxes on Annuities Work?

Annuities are a great, safe way to earn interest on your money, but we get asked this question quite a bit: do you have to pay taxes on annuities?

For starters, there are many different kinds of annuities. Since we work in the senior market, we typically focus on one kind of annuity, which is a fixed annuity. If you want to know more about how those work, read Want to Stay Safe From Stock Market Corrections? Here’s How.

There are two main events that happen when you have an annuity:

1. When you put your money into it
2. When you take your money out

Those events can potentially cause a tax to take place, but what are the circumstances? What should you expect?

Annuity Taxation: When You Make the Investment

When you put your money into an annuity, it’s important to first determine where that money is coming from.

In our experience, an annuity is usually funded in one of two ways:

1. It comes from an IRA or a 401(k)
2. It comes from your bank (savings, checking, money market, or CD)

There are two more situations that are more rare, so we won’t cover them in great detail, but just so you know:

1. It can come from an insurance company (existing annuity or life insurance policy)
2. It can come from an investment firm

Did your money come from an IRA or a 401(k)?

If your money is transferred from one institution to the next, this is a non-taxable event.

That means that you can transfer your IRA or 401(k) funds into an annuity without having to pay taxes.

We generally refer to this as rolling your money from your IRA or 401(k) to the annuity.

Did your money come from the bank?

If the money came from a Bank IRA, you can do a direct transfer to the annuity, or you can move those funds to your checking account and write a check within 60 days. These are non-taxable events.

The same goes for savings, money markets, or CDs – just move those funds to your checking account, and write a check towards the annuity.

Did the money come from an insurance company?

You have the option to use an existing annuity or a life insurance policy to fund an annuity. Sometimes, this can make a lot of sense, while in other situations, you’re best to stay put. Make sure to have a thorough consultation with one of our agents before making this type of a decision.

In these circumstances, your agent would do what is called a 1035 exchange. This allows the transfer of the funds to be a non-taxable event.

Did the money come from an investment firm?

If the money comes from an investment firm, they would complete a transfer form – no personal check required. Once again, this is considered a non-taxable event.

Annuity Withdrawal Tax Penalty

When you want to withdraw money from your annuity, there’s a chance you could pay taxes on that money. Once again, it depends on where the money came from. Here’s the deciding factor:

1. If your deposit was pre-tax money, you will pay taxes on your withdrawals.
2. If you already paid taxes on your deposit, you will only pay taxes on your growth.

I know this concept can seem a little bit complicated, so I’m going to give some examples.

Did your money come from an IRA or a 401(k)?

When you retire, it’s very common to move your IRA or 401(k) funds to a fixed annuity. Unlike the stock market, there’s zero risk, and you still have the opportunity to earn good interest on your money.

Whatever you do, don’t put that money into a CD or a Money Market – you can learn more about why here.

Now, money that is in your IRA or 401(k) has never been taxed. You haven’t paid taxes on it, and your employer hasn’t paid taxes on it.

When you transfer that money to an annuity, is grows tax-deferred. That means there are no taxes being taken out of that deposit while it’s in the annuity.

However, when you’re ready to withdrawal the money, you will pay taxes on it.

So, to sum up: IRAs and 401(k)s have never been taxed. They grow tax-deferred in your annuity until you make a withdrawal. Then, 100% of your withdrawal will be taxed as taxable income.

Did your money come from the bank?

Let’s say you have a sum of money in your savings account. You don’t need it for anything, and it’s only earning 0.1% in the account (or whatever your bank’s interest rate is for savings accounts).

That money would be put to good use in a fixed annuity. What’s nice about this is that your savings have already been taxed – you’ve already paid taxes on that money.

So, your deposit will grow tax deferred, and when you’re ready to make a withdrawal, you’ll only pay taxes on the interest you earned.

You don’t pay any taxes on the original deposit amount, because then you’d be paying taxes twice. You only pay interest on any gains that were made in that annuity contract.

Keep in mind that most people don’t want to take all of their money out at one time. They’ll take out what they need, and they’ll start up another contract.

When your contract is over, you have the opportunity to “shop the market” and see if any other company is offering a better interest rate. Then, you can just start up another contract and continue earning interest.

Annuity Withdrawal Before (or After) 59 1/2

There is one annuity tax rule you need to know about:

• You can’t withdraw that money before age 59 ½, or you will pay a 10% tax penalty.

It’s a simple rule to understand, but don’t make the mistake of withdrawing any money before you turn 59 ½. Losing 10% of your money when you didn’t have to is really… well, it’s a huge inconvenience.

After the age of 59 ½? It’s fair game.

Taxes on Annuities: What You Really Need to Know

We hope this was easy to understand, but just to make sure you got it, here’s really all you need to know:

1. There’s almost always a way to transfer your money into an annuity without having a taxable event.
2. The tax benefit of an annuity is that your money grows tax-deferred.
3. If you haven’t paid taxes on the money yet, you will have to eventually.

And that’s really the gist of it.

If you have a sum of money that you’re not using, and you’d like to earn a little better than 3% interest on that money – with zero risk of losing it – we’d encourage you to contact us for a free consultation.

You can generally start a fixed annuity contract with as little as $10,000, so don’t hesitate to contact us. We’d love to put your hard earned savings to work for you!