How Are Annuity Payments Taxed?
Annuity payments are generally taxed as ordinary income. When you receive payments from an annuity, the taxation depends on whether the annuity is qualified or non-qualified. Qualified annuities are funded with pre-tax dollars, while non-qualified annuities are funded with after-tax dollars.
Qualified Annuities
For qualified annuities, such as those held in an IRA or a 401(k), the entire distribution amount is taxable as income when you start receiving payments. You do not pay taxes on these funds until withdrawal, at which point they are subject to your ordinary income tax rate.
Non-Qualified Annuities
In the case of non-qualified annuities, you only pay taxes on the earnings portion of the payment. The original investment (principal) is returned tax-free as you have already paid taxes on that amount. The IRS uses the "last in, first out" (LIFO) method for taxation, meaning that earnings are considered to be withdrawn first.
Tax Penalties
If you withdraw funds from your annuity before reaching age 59½, you may incur a 10% early withdrawal penalty in addition to regular income tax. Always consult with a tax professional to understand how annuity payments will affect your tax situation.
Conclusion
Understanding the tax implications of annuity payments can help you better plan for retirement. Be aware of how qualified and non-qualified annuities differ in terms of taxation to make informed investment decisions.