Annuities are taxed kind of as a hybrid between “qualified” retirement plans and IRAs and regular taxable investments.
Annuities in IRAs, 401ks and other qualified retirement plans
For annuities inside such plans like IRAs, 401ks, TSA/403bs, etc., the IRA tax treatment controls, and the entire value of the annuity—initial investment and all the growth—will be taxed as ordinary income in the year you take it out, which means you will pay your highest tax bracket on the distributions.
In other words, they are treated just like any other investment in such an IRA for tax purposes. The same is generally true for ROTHs —tax-free treatment once the ROTH criteria have been satisfied—but check with your tax advisor to be sure.
Taxes on non-qualified/non-IRA annuities – oppressive tax treatment
Annuities outside of retirement plans—so-called “non-qualified” annuities, those you buy with after tax money— “enjoy” their own rather quirky tax treatment, which can prove rather oppressive.
For one thing, the tax treatment is ordinary income (again, read your highest marginal tax rate), which can be double the rate on capital gains, generally applied to stocks and much mutual funds growth.
Annuities’ taxes can be double those on other investments – plus a 10% penalty?
This is worth underscoring: annuities’ growth is generally taxed at up to double the rates on other types of investments. This can be a real damper on the wealth value for consumers who can only consume what’s left after taxes.
And while the gains on non-qualified annuities are deferred—which means you don’t pay tax until you actually pull money out of the contract—the same sort of 10% penalty as for IRAs applies to pre-59 ½ distributions. In that case, you pay your highest marginal tax rate (and the distribution can easily put you into a higher bracket), plus 10% of the taxable distribution.
Annuities tax deferral more expensive than stocks and ETFs
This is quite different from capital gains treatment on things like stocks, which are also deferred until you choose to recognize the gain, and come with no pre 59 ½ 10% additional excise penalty, besides having a top tax rate about half of the top ordinary income tax rate.
Annuities LIFO tax rules – front loaded taxes unlike other investments
Finally, annuities are subject to last-in-last-out (“LIFO”) rules, which mean you have to pay the tax on all of the gain before getting your initial investment back tax-free. This treatment can bunch taxable events, accelerate taxation, and drive higher rates, all of which can reduce the amount left for you and your family. This is also quite different from the rules for capital gains, which can be much more flexible in letting you and your tax advisor pick your tax shots, reducing tax recognition and better controlling rates to yield more for you.
Annuities – worst tax rules in the investment world?
In many ways, non-qualified annuities are saddled with some of the worst tax rules for investors, and this should give many investors pause.
Silver lining on annuities losses – ordinary beats capital losses
On the other hand, losses on annuities are “ordinary losses” and can be deducted against other sources of income, like wages, without limit (a big advantage over capital losses).
Those who are down should consider the wisdom of this exit ramp, especially during down market cycles where this applies more frequently.
Annuities tax losses – an annuity rescue opportunity?
This can be a big value tax strategy for those “stuck” in annuities.
Tax deferred annuity exchanges – IRC 1035
Finally, those with gains should consider “1035” (the number refers to an Internal Revenue Code section permitting this technique) exchanges, which allow tax-deferred “rollovers” between annuities. This can be a big help in getting out of expensive, poorly-managed annuities and into low-cost, no-load products while avoiding current taxation.