How Much Tax Will I Owe On My Income Annuity?
Getting back to our calculation, if you now divide $100,000 (your "investment") by $132,000 (your "expected return") you get a percentage equal to 75%. That's how much of each $550 check is your initial after-tax investment being returned to you, and, therefore, is not taxable or "excludable" from income tax.
Of course, the balance (i.e., 100% minus 75%, or, 25%) is the taxable portion of each monthly payment. In our example this amount is $138 (i.e., 25% of $550). This number ($138) would be found under the "Taxable Income" heading on your quote spreadsheet, if you were 65 and investing $100,000.
By January 31st of each year, you should receive a Form 1099-R from your insurance company with the prior year's taxable income. Using the above example, your 1099 would show taxable income of $138 times 12, or, $1,656.
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Getting a monthly check that's largely tax-free is an important feature of income annuities. Keep in mind, however, that not all good things last forever. The total amount of income that is excluded from taxes each year (75% in the above example) cannot exceed the total amount that you originally put into the annuity when you purchased it.
Should you have the good fortune to live longer than the IRS’s life expectancy tables indicate, your entire monthly draw from the annuity beginning at that time (i.e., at age 85 for a 65 year old annuity buyer) would be considered earnings, and therefore taxable.
If you're like most annuity holders who reach this longevity threshold you'd have moved into a lower tax bracket than during your working years, and may find this a great strategy for deferring taxes until they are less expensive.
The bottom line is that with income annuities the IRS allows you to amortize over your life expectancy the interest earnings that you are receiving, significantly reducing the upfront tax burden that might occur from other types of investments, including multi-year deferred and indexed annuities.
Note: This discussion does not apply if you're buying your immediate or deferred income annuity with Traditional IRA or 401k dollars, when 100% of each month's payments would be taxable, since no portion of any payment represents after-tax monies.
Conversely, an income annuity purchased with Roth IRA monies would generate completely tax-free income, which is true for any withdrawals from a Roth IRA.