Understanding Annuity Taxes and How They Affect You

Planning for retirement can feel overwhelming, and taxes often make it even more complicated.

If you’re considering an annuity or already own one, you might wonder how it will impact your taxes. The good news is the basics are simple: Annuities let your money grow without yearly taxes, and you pay taxes later when you take the money out.

In this blog, we’ll explain how annuities affect your taxes, the benefits and drawbacks, what happens if you take money out early, and what your loved ones need to know if they inherit an annuity.

What Is an Annuity?

Think of an annuity as a contract with an insurance company that turns your savings into regular income, often during retirement. You can fund it with one payment or several payments over time.

One of the biggest advantages of an annuity is tax-deferred growth. That means you don’t pay taxes on earnings each year. Instead, you pay later when you withdraw money or start receiving payments.

Here’s why this matters: When you take money out, the taxable portion counts as ordinary income. You pay the same rate you pay on wages, not the lower capital gains rate you might get with stocks.

A hypothetical example makes this clear. You put in $10,000. It grows to $15,000. You pay taxes on the $5,000 of growth when you take it out. Until then, it keeps growing and working for you.

Do Annuities Help You Save on Taxes?

Here’s the good news: Annuities grow without yearly taxes, which boosts compounding over time. For some people, paying taxes later in retirement makes sense if they expect to be in a lower tax bracket. It’s not guaranteed, but that’s one reason annuities attract long-term planners.

If your annuity sits inside a retirement account like an IRA, it counts as a qualified annuity, and you must take required minimum distributions (RMDs) at age 73 or 75, depending on when you were born. Non-qualified annuities, which you fund with after-tax dollars, don’t require lifetime RMDs. That gives you more control over when you take income.

Tax Benefits of Annuities

Here’s what makes annuities attractive:

• Tax-deferred growth: You don’t pay taxes on earnings each year, which can help your money compound faster.
• Flexibility for non-qualified annuities: No lifetime RMDs mean you can choose when to take income based on your needs.

Tax Drawbacks of Annuities

Annuities aren’t perfect. Here’s what to watch for:

• Ordinary income taxes: You pay taxes on the earnings at your regular income tax rate when you withdraw.
• Early withdrawal penalty: If you take money out before age 59½, you may owe a 10% IRS penalty on top of taxes. There are exceptions, but they’re limited.
• Fees and surrender charges: Many annuities have costs if you cash out early. These can add up, so know your contract before making moves.

What Happens When You Take Money Out?

You can take money from an annuity in two ways: withdrawals or income payments.

• Withdrawals: Depending on your contract, surrender charges may apply. Taxes are generally applied to earnings first. You’ll get a tax form showing the taxable amount.
• Income payments: If you turn your annuity into a paycheck, each payment often includes a mix of taxable earnings and a tax-free return of your original money.

Do Beneficiaries Pay Taxes on Annuities?

If someone inherits your annuity, the untaxed earnings are generally taxable to them. This is different from life insurance, which usually pays income tax free. Beneficiaries may choose a lump sum or payments over time, and taxes depend on that choice.

Answers to Common Questions

Are annuities tax free?

No. They offer tax-deferred growth, but taxes apply when you withdraw money or receive payments.

Do I pay taxes when I withdraw money?

Yes, on the earnings portion. You’ll get a tax form showing the taxable amount.

What if I take money before 59½?

You may owe a 10% penalty plus regular income taxes.

What to Do Next

Understanding how annuities affect your taxes plays an important role in planning for retirement. If you’re thinking about adding an annuity to your strategy or you already have one, take the next step. Talk to someone who can walk you through your options and explain how taxes might shape your decisions.

To learn more about WoodmenLife’s retirement options, visit WoodmenLife.org/Retirement.

Written by: Diana Henry, Senior Digital Copywriter

This blog is intended for general educational purposes only and may reference products, features, or options not currently offered by WoodmenLife. Availability of products and features can vary by company and state.
WoodmenLife, its employees, and Representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.

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