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Annuity Payments Tax Treatment

An annuity is a contract issued by an insurance company and is usually referred to as an annuity policy or an annuity contract. What makes annuities different is the tax treatment given to them by the Internal Revenue Service (IRS). Think of an annuity as an umbrella. When money is placed under the umbrella or annuity contract, it is treated differently as far as taxes go. Typically annuities are given tax-free.

Annuities are generally one’s original contribution or principal contribution. Since one has already paid taxes on it, it will never be taxed again. The money put in an annuity is referred to as a premium subject to taxation. That said there are still exceptions to taxations, and specifically penalties can be incurred for pre-mature withdrawals of annuities. This assumes that one has not purchased an annuity as part of a qualified retirement program such as:

  • IRA
  • 401(K)
  • TSA
  • 457 plan

The funds that are put into an annuity will earn interest or receive dividend income or capital gain distributions. These earnings, unlike money in a savings account, mutual fund, certificate of deposit are not taxed in the year in which they are earned. Thus the earnings will continue to grow and compound tax free until withdrawn.

Avoid Pre-Mature Withdrawals

In many states, one can sell the rights to periodic payments to a company that will pay you a lump sum today. While a lump sum of money is definitely tempting to receive all at once, it is typically not the smartest way to go. Cashing out today for a quick cash fix can mean netting far less than you would get down the road if you keep the payments. It is important that one weighs all the options carefully before cashing in, since once you cash in on an annuity it can not be undone. Not to mention, cashing in on the annuities will result in heavy taxation.

When you withdraw money from your annuity, the earnings, according to the IRS, are
withdrawn first. The “earnings” are subject to “ordinary income taxes” in the year in which they are withdrawn. Keep in mind that capital gain distributions in a mutual fund are taxed at capital gains rates.

The IRS also has what it calls “Premature Distributions”. If you withdraw your earnings and your under the age of 59 ½. Not only are earnings taxed at ordinary income tax rates, but also the IRS makes you pay a penalty of an additional 10% on the earnings that are taxed. The IRS eventually collects taxes on the “earnings” of your annuity.

Exceptions To Withdrawals

There are no penalties on distributions made after you are age 59 ½. Also no penalty exists if the withdrawal is made on or after the death of the owner of the annuity. Disability is also an exemption and will not incur the tax penalties. Additionally no penalties will exist if the withdrawal is made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.