Episode 31: How are Annuities Taxed?

Today we’re going to take a look at how are annuities taxed.

Taxes can be incredibly complex, and it’s important to remember that this discussion will provide a 30,000-foot view. For any detailed tax planning, you should always consult with a tax professional.

The goal here is to offer an educational overview of the taxation of annuities. We’ll break down the different types of money—non-qualified, qualified, and Roth—and explain how each interacts with annuities, highlighting the key tax implications. So again, this is just for educational purposes only, and will be a very high level discussion on how annuities are taxed.

Types of Money: Non-Qualified, Qualified, and Roth

For the average individual, understanding the different types of money is crucial, as it can significantly impact your financial planning and tax strategies. There are essentially three types of money: non-qualified, qualified, and Roth.

Non-qualified money is essentially money that you’ve already paid taxes on. This is the type of money you might find in your savings or checking account, a bank CD, or a brokerage account. The key characteristic of non-qualified money is that while you’ve paid taxes on the principal amount, you will still owe taxes on any interest or growth it generates.

Qualified money, on the other hand, is money that has been tax-deferred. This means you haven’t paid any taxes on the principal or the growth yet. The most common examples of qualified money are funds in retirement accounts like 401(k)s, 403(b)s, 457 plans, TSPs, and IRAs. The advantage here is that you can reduce your taxable income in the year you make the contribution, but you will owe taxes when you withdraw the funds in retirement.

Lastly, there’s Roth money. With Roth accounts, such as a Roth IRA or Roth 401(k), you’ve already paid taxes on the money you contribute. The significant benefit of Roth accounts is that all the growth and withdrawals are completely tax-free, provided certain conditions are met. This can be a powerful tool for tax planning, especially if you anticipate being in a higher tax bracket in retirement.

Now that we’ve outlined these three types of money, we’ll explore how each type interacts with different kinds of annuities and what implications that has for your tax situation.

Non-Qualified Money and Annuities

If you fund an annuity with after-tax dollars, referred to as non-qualified money, then all of the growth inside of that annuity can be deferred for tax purposes indefinitely. This means that unlike other non-qualified vehicles like CDs, bonds, or high-yield savings accounts, where you have to pay taxes on the interest earned each year, non-qualified annuities allow you to defer these taxes until you withdraw the funds.

When you eventually pull money out of a non-qualified annuity, the growth portion will be taxed as ordinary income. However, if you only withdraw a portion of the annuity, the IRS uses the LIFO (Last In, First Out) method, meaning the growth—considered the last money in—will be the first to come out and be taxed. For instance, if you have a $100,000 annuity that has grown to $110,000 and you withdraw $10,000, you will owe taxes on that entire $10,000. If you withdraw $15,000, you will owe taxes on the first $10,000 of growth, while the remaining $5,000 is considered a return of principal and is not taxable.

This tax deferral feature makes non-qualified annuities an attractive option for those looking to grow their investments without the immediate tax burden. So, you don’t owe tax on that principal amount when you withdraw it.

Income Annuities and the Exclusion Ratio

Now, if you fund an income annuity with non-qualified dollars, an income annuity meaning we’re putting the money in and we’re going to get a guaranteed lifetime income out, no matter how long we live, you’re going to fall into something called an exclusion ratio. The exclusion ratio is a calculation used by the IRS to determine what portion of each annuity payment is considered a return of your principal (which is not taxable) and what portion is considered earnings (which are taxable).

The exclusion ratio is based on your life expectancy, as determined by the IRS Uniform Lifetime Table. Essentially, part of your annuity payment is tax-free because it is viewed as a return of the money you originally invested, and part of it is taxable income. This ratio remains in effect until the original investment is fully recovered.

Even once the value of the annuity reaches zero—meaning there’s no account value and no death benefit left—the income continues for as long as you live. At that point, however, the entire amount of the income becomes taxable since it is no longer considered a return of principal.

This feature ensures that you have a stable, lifelong income stream, which is the primary purpose of an income annuity. So, even if the annuity runs out of money, you’re never going to run out of income, which is the whole point of an income annuity.

1035 Exchanges and Long-Term Care Annuities

Now, here’s one little gem that a lot of people don’t know about with non-qualified annuities. If you have a non-qualified annuity that has experienced growth and you don’t need or want to withdraw the funds currently, you can perform a 1035 exchange into a long-term care annuity. This allows you to move the entire value of your non-qualified annuity into a long-term care policy, where it can continue to grow.

The significant advantage here is that when you qualify for long-term care benefits, the money paid out from the annuity for those expenses is completely tax-free. This is an exceptional strategy for addressing potential long-term care needs, which statistically, many of us will face at some point in our lives. It’s a smart way to leverage your annuity’s growth to cover future healthcare costs without incurring a tax burden on those funds.

So, if you have a non-qualified annuity and are considering your options, this 1035 exchange into a long-term care annuity is definitely worth exploring. Keep this little loophole in your back pocket, because that’s really, really important.

Using Qualified Money to Fund Annuities

Qualified money includes funds from accounts like 401(k)s, IRAs, 403(b)s, and other retirement plans. When you move qualified money into an annuity, the rules regarding taxation remain consistent: any withdrawals, whether they are from the interest growth, principal, or guaranteed income, will be subject to ordinary income tax.

Many people are often surprised by this because they see the balance in their retirement accounts and might not immediately realize that a portion of that money is owed to Uncle Sam. It’s important to understand that you will owe taxes on these funds when you start taking distributions, regardless of how they are invested or utilized.

However, there are strategies to help extend the life of your qualified money and protect it from market downturns, such as using the Atlas RMD Rescue Plan, which I’ll link in the show notes and on the website. This can help you manage your withdrawals more effectively and mitigate some tax impacts.

Just remember, if you have qualified money in retirement accounts, you will have to pay taxes on it at some point. There is no way around that.

Roth Money and Annuities

Okay, now the last category of money is Roth money. Roth accounts, such as Roth IRAs or Roth 401(k)s, are unique because they offer tax-free growth and tax-free withdrawals, provided certain conditions are met. This means that the money you contribute to a Roth account has already been taxed, but any future earnings and withdrawals in retirement are completely tax-free.

This can be a powerful tool for retirement planning, especially if you expect to be in a higher tax bracket in the future. Whether you are funding a Roth growth annuity or a Roth income annuity, the principle remains the same: the money grows tax-free and can be withdrawn tax-free, providing a significant advantage over other types of accounts.

The other way to get money into a Roth account is through a Roth conversion. This involves transferring funds from a traditional IRA or another qualified account into a Roth IRA. You will pay taxes on the amount converted, but future growth and withdrawals will be tax-free. So, you can do that as well.

The Benefits and Timing of Roth Conversions

Regardless of whether you do a Roth growth annuity or a Roth income annuity, anything that comes out of it at that point is completely tax-free. This makes Roth conversions an attractive option, especially in light of potential changes to tax laws. For example, if you believe tax rates will increase in the future, converting to a Roth account now could save you money in the long run.

As of June 2024, there’s considerable discussion about the potential expiration of the Trump tax cuts, which is prompting many to consider Roth conversions. While it’s important not to make decisions based on fear or speculation, there is always a place for Roth conversions in a well-thought-out financial plan.

If you’re considering a Roth conversion, it’s crucial to do so strategically. You want to avoid bumping into a higher tax bracket, so it’s often best to convert just enough to maximize your current bracket without spilling into the next one. This requires careful planning, and I have software that can help determine the optimal conversion amount for your situation.

Remember, the best time to start tax planning was 30 years ago. The next best time is now. By planning strategically, you can take advantage of your options to minimize your tax burden and maximize your retirement savings.

In the podcast episode, you’ll see how this works in several situations, so you’ll have a more clear idea of how annuities are taxed.

Podcast Episode 31: How Are Annuities Taxed?

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