How Much Tax Will I Owe On My Income Annuity?

Written by Hersh Stern Updated Wednesday, November 28, 2018

The topic of retirement planning would not be complete without taking a look at how an income annuity would affect your taxes.

As you well know from a lifetime of working, income taxes can make a real impact on your monthly budget, so no plan would be complete without factoring in this important detail.

The way income is taxed is quite different from many other investments and, even, other annuities. In fact, the tax burden can be much lighter than dividend distributions from stocks or bonds.

When you buy an income annuity with after-tax savings (i.e., with so-called "non-qualified" monies), the IRS recognizes that that money has had taxes already paid on it.

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For this reason, as you receive each month's payment from the annuity, you are only taxed on that portion of each payment which represents new earnings: meaning, the new interest your annuity is generating (above the principal you receive). You are not taxed a second time on the portion of each payment which represents a return of your previously-taxed principal.

This approach to calculating the taxes on your annuity is called the "exclusion ratio" or "pro rata" method and it's computed using the IRS General Rule (see IRS Publication 939). You can read more about the Rule on the IRS site.

When you receive quotations for immediate and deferred income annuities, you will notice a section listing the taxable portion of your annuity payment. If you'd like to understand how the insurance company determines which portion of your payments should be taxable, I can walk you through an example.

Say you're considering investing $100,000 in an immediate or deferred income annuity, you're age 65, and the insurance company has agreed to pay you $550 a month for your lifetime.

Referring to Table V in IRS Publication 939 (see page 26) we find the so-called "multiple" for age 65 to be 20. This word, "multiple," is how the IRS refers to your life expectancy. In other words, the IRS expects a 65 year old to live for 20 years.

So, if you multiply your monthly income (which we assumed to be $550) by 12 months you compute an annual income of $6,600. Next, we take this annual income figure of $6,600 and multiply it by the IRS life expectancy "multiple" of 20 and get $132,000.

So the IRS assumes that a 65 year old will receive $132,000 ($6,600 x 20) over his lifetime based on a $100,000 annuity investment. How much you actually receive will depend on your health and longevity.

So how much of my payments will be taxable?

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Comments (16)

  1. Brad:
    Oct 07, 2014 at 02:52 PM

    Will the annuity company withhold for Federal and state income taxes? Can I be assured that the IRS gets paid? How do the "mechanics" of this work?

  2. Hersh Stern:
    Oct 07, 2014 at 04:10 PM

    Hi Brad,

    With most companies, there is a section on the annuity application where you can elect (it’s at your discretion) whether or not to have the insurance company withhold a specific dollar amount or percentage of each payment for federal income taxes. Some companies use a W-4P form, instead, which is the official IRS form used for withholding from pension or annuity payments. So you can be 100% assured that the IRS will get paid.

    Regarding the withholding of state income taxes, some companies do and some don’t handle this. The state amounts needed to be withheld are usually very small relative to the gross amount of your monthly annuity payment.

    -Hersh

  3. Wendell Read:
    Nov 03, 2014 at 04:07 PM

    Thanks for the tax info. I have a Roth IRA. If I were to get an immediate annuity would I withdraw the money from my Roth IRA and then buy the annuity, or would the company issuing the annuity directly withdraw the funds from my Roth IRA (with my permission of course)?

  4. Hersh Stern:
    Nov 03, 2014 at 07:40 PM

    Hi Wendell-

    Nice to hear from you, too.

    Typically, the insurance company will request the money from your existing Roth IRA custodian. This is done via a Transfer Authorization form you sign at the time you sign the application (we can send you those forms). Keep in mind that your Roth IRA must be “qualified,” meaning, the account is at least 5 years old for payments you receive from the immediate annuity to be tax-free. If you have further questions about this, call me at 800-872-6684.

    Hersh

  5. bev:
    Nov 03, 2014 at 08:32 PM

    with an income annuity that has a COLA based on CPIU how is the non-taxable portion of each payment computed (since it is not possible to compute the expected payments over the annuitants life time because the cost of living adjustments to be made over the years are not known)?

  6. Hersh Stern:
    Nov 04, 2014 at 04:54 PM

    Hi Bev-

    This is a great question and I simply don’t know the technical answer. I did check comparative quotes from the only two companies I know that market CPI increases in their deferred income annuities. These quotes (from American General and Principal Financial) indicate that whatever method they are using both companies came up with remarkably similar calculations for the excluded amounts.

    American General offered $2,133 per month with an excluded amount of $1,657.
    Principal Financial offered $2,001 per month with an excluded amount of $1,645.

    So my best guess is that the IRS is providing insurance companies with guidelines for how to arrive at this calculation in spite of the uncertainty about the level of future increases in the CPI. Thanks for asking.

    Hersh

  7. Cynthia:
    May 21, 2015 at 10:25 AM

    I received your immediate annuity quotes and wondered what the column titled "taxable interest portion" means in practical terms (what records do I keep, for example)?

  8. Hersh Stern:
    May 21, 2015 at 10:26 AM

    Hi Cynthia-

    Good to hear from you, too.

    Briefly, taxable income is similar to interest earnings that you may receive on a bank account and for which the bank sends you a Form 1099 at the end of the year. Similarly, the insurance company sends you a 1099 which tells you how much of the total income you got from your annuity that year was taxable. So, if you are in the 25% federal tax bracket, then 25% of this “taxable income” amount on your Form 1099 needs to be paid to Uncle Sam.

    -Hersh

  9. Dan:
    Jun 05, 2015 at 04:04 PM

    I will be 63 and my spouse 56 when we begin our joint life immediate annuity. Please discuss taxes if my spouse continues to receive income from this annuity after I die.

  10. Hersh Stern:
    Jun 05, 2015 at 04:05 PM

    Hi Dan-

    Any conversation about income taxes on an immediate annuity payment must start by defining the tax status of the premium dollars used to buy that annuity. If the source was an IRA or 401k then all the income distributed by that annuity will be taxable for as long as you and your spouse receive income from it.

    If you pay for your annuity with after-tax savings then the IRS recognizes that a part of your monthly income is really your own after-tax premium being paid back to you. So the IRS does NOT require you to pay income tax on that amount. You only owe income tax on the new interest you earn which had not been previously taxed.

    When you shop for an annuity at our firm we tell you up-front what portion of each check is taxable income and how much is not subject to any income tax.

    The non-taxable portion or percentage is known as the “exclusion ratio.” This percentage remains unchanged each month for the duration of your annuity UNTIL you and your spouse have recouped ALL of your original after-tax investment (aka your “cost basis” in the contract).

    From then on your monthly income is considered to be all gains (i.e., all new earned interest) and therefore subject to income taxes.

    -Hersh

  11. Mike:
    Jul 27, 2015 at 10:43 AM

    How much federal tax do I have to pay on a fixed annuity in which there is no history of withdrawals and I withdraw at once in a lump sum all the annuity?

  12. Hersh Stern:
    Jul 27, 2015 at 10:44 AM

    Hi Mike,

    If you bought your annuity with after-tax savings, then income tax is owed only on the gains. Taxes are at your ordinary income tax rate, not capital gains rate.

    If you bought your annuity with IRA or 401k pre-tax money, then tax is owed on the whole lump sum unless you roll it over into another tax-qualified account within 60 days. Again, taxes are at your ordinary income tax rate.

    Hersh

  13. Mia:
    Aug 10, 2015 at 09:16 AM

    1. Funds from my 401K rolled over to an Immediate Annuity, is this tax free from the IRS & State of CA?

    2. Monthly income from Immediate Annuities, is this Taxed by the IRS & State of California?

  14. Hersh Stern:
    Aug 10, 2015 at 09:17 AM

    Hi Mia-

    1. Yes, you can roll over your 401k to an immediate annuity tax free. Read more about this here:

    https://www.immediateannuities.com/roll-over-ira-or-401k/

    2. Monthly income from your immediate annuity which was purchased with pre-tax 401k money is subject to ordinary federal income tax.

    Regarding California income tax on retirement income: Some states exclude all or a portion of income withdrawn from an IRA or 401k. However, there are at least five states which offer no safe haven for retirement income. California is one of the five. California also imposes a 2.5% penalty for those who withdraw from a retirement plan before age 59 1/2. This is in addition to the 10% pre-59-1/2 federal penalty.

    Hersh

  15. Hugh:
    Feb 09, 2016 at 03:55 PM

    Is the monthly benefit taxed as regular income?

  16. Hersh Stern:
    Feb 09, 2016 at 03:55 PM

    Hi Hugh-

    Yes. I looked up the quotes you created at our web site. For “source of funding” you describes the premium as “Savings” which typically is after-tax money. Now, on the page with quotations you’ll see a column titled “Taxable Portion.” This is the amount of taxable interest or gains you earn each month. Say you’re in the 20% tax bracket. Then the amount each month you owe to Uncle Sam would be 20% of the “taxable portion.”

    If, on the other hand, you decide to buy your annuity with IRA or 401k money, then the full amount of each monthly payment would be taxed as ordinary income.

    Hersh