Income annuities may be one of the simplest retirement products on the market: you put a set amount of money of your choosing into the annuity, and in return, you get a set amount back every month for life. But the way annuities are taxed can be confusing, even for those who easily understand the basic mechanics of how an income annuity works.
To help take the confusion out of taxes and annuities, here are your top 5 annuities tax questions, answered:
1. How are income annuities taxed?
It’s important to first understand how your payment amount is determined. Once you decide how much you’ll put into the annuity, the company issuing the income annuity decides how much income you’ll receive each month in return. The payment amount is determined by a few different factors, mainly your age at time of purchase, your gender, and the type of income annuity you select. While the income is sent to you in one seamless amount each month, for tax purposes, the money is coming from two distinct “buckets”: your original investment, and whatever additional gains the issuing company is paying on top of your initial purchase amount.
So, how your income annuity is taxed depends mostly on how the annuity was paid for to begin with. If you purchase an income annuity with after-tax funds – that is, money on which you’ve already paid income tax – then income taxes will apply to the gains “bucket.” You won’t be taxed on any of the money that was used to purchase the annuity, because you’ve already paid those taxes. However, if the funds to purchase your income annuity are coming from a pre-tax source, then you’ll pay income taxes on 100% of your monthly payment (since none of that money has been taxed before). In both cases, the income taxes will only be due once you start receiving payments.
2. Are there tax benefits to income annuities?
Again, the exact tax benefits of an income annuity depend on the money it’s purchased with. For example, if you purchase an income annuity with funds that have not been taxed, then you’ll only be taxed on the money used to buy the annuity once you start receiving income payments. Furthermore, you’ll only be taxed on the principal amount in each payment. So instead of paying your income tax all at once, like you would with a lump-sum distribution, you’ll break up your tax payments into smaller, more manageable amounts.
3. Are there potential tax drawbacks with income annuities?
There usually aren’t tax drawbacks associated with annuities. However, if you take out more than your fixed monthly payment (through a payment acceleration feature), you would pay income tax on that money right away, so you’ll want to take that into consideration if you decide to use that feature. Also, income taxes would be due on any money paid to a beneficiary after the annuity owner’s death at the time it’s given out.
4. Are there tax differences between an immediate income annuity and a deferred income annuity?
The same basic tax rules apply whether your payments begin immediately or are deferred to start at a later date. The main difference is that a deferred income annuity allows you to continue adding funds to the annuity over time, up until two years before your payments begin. The more money you add to your income annuity, the higher your monthly income payment, which means the taxes you’ll pay will go up, too, based on the standard income tax rate.
5. What can I do if I still have questions?
While there’s a lot of helpful information on the internet (including the New York Life Learning Center), it’s natural to have questions specific to your situation that can’t easily be answered by reading articles or watching videos. In those cases, it’s best to speak with a knowledgeable expert, such as a trusted tax professional. A reputable professional will understand that no one solution is right for everyone, and will help you uncover the information relevant to your personal needs so you can make the right decision.
Learn more about annuities in the New York Life Learning Center, or call 1-800-313-6841 to have your questions answered by a knowledgeable representative.