Taxation of Annuities

Everybody wants to protect his/her money or income from taxes. Most of the annuity plan allows to grow the money tax-deferred. As long as the money remains inside the annuity, the government won't tax any of the earnings. But there comes a situation when annuity is also taxed. Let's see how it occurs. Taxation of annuities differs from plan to plan depending on various factors like time period, withdrawal, in which plan the annuitant is investing and the insurance company etc.

In a deferred annuity there are mainly two phases. The first phase is accumulated phase and second is distribution phase. During the first phase i.e. accumulated phase the annuity continuously grows untaxed through the years as the investment compounds.

The second phase i.e. distribution phase in which the annuity is paid out. The payment is made as a lump sum amount or as a series of monthly payments for a specified period or a lifetime.

A series of scheduled payments is called "annuitization," and the recipient is called the "annuitant."

Regardless of the payment method, some income taxes will by due on every annuity payment the annuitant receives. If the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into that annuity and its value when it is paid back.

Taxes on a Lump-sum Distribution:

A lump-sum distribution is the distribution, within a single tax year, of a plan participant's entire balance from all of the employer's qualified pension, profit-sharing, or stock bonus plans. All the participants accounts under the employer's qualified pension, profit-sharing, or stock bonus plans must be distributed in order to be a lump-sum distribution.

As an example, let's say you invested $100,000 over the years into a TransFirstLife annuity that's worth $250,000 when you retire at age 62. If you take that amount in a lump sum, you will owe taxes on your gain of $150,000.

Taxes on Variable Annuities:

A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. Those payments are taxed based on when the annuity was purchased. Investments made after August 13, 1982, are taxed on a last-in, first-out basis. That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract. Additionally, just like a traditional IRA, withdrawals made prior to the annuitant's age 59½ are subject to a 10% early withdrawal penalty.