Understanding how annuities are treated under the tax code

By Jason Kestler

Kestler Financial Group, Inc.


A nice tax advantage offered by annuities is that you can earn interest and not have to pay taxes on that interest right away.

For tax purposes, your annuity can be treated one of three ways: as a traditional IRA, as a Roth IRA or as a non-qualified annuity.

What makes an annuity a traditional IRA?

Perhaps you have money in a corporate retirement plan like a 401(k), 403(b), or 457 plan, or in an existing IRA. That money can be transferred or rolled over from the existing account into an annuity.

As long as the annuity is designated on the application as a traditional IRA, then the entire amount that goes into the annuity is a tax-free exchange. As interest is credited to the annuity, it can stay in the annuity, and no taxable income is reported to you. However, as with all traditional IRAs — and as with all corporate retirement plans, for that matter — when you ultimately take withdrawals, the entire amount of each withdrawal is taxed as ordinary income.

Keep in mind that the Internal Revenue Code provides tax deferral to IRAs, so there is no additional tax benefit gained by funding an IRA with an annuity. Consider the other benefits provided by an annuity to determine if an annuity is the right choice for your IRA.

What kind of money is considered non-qualified?

Your general savings or investments are considered non-qualified. It simply means money that never went into a tax-qualified corporate retirement plan or any type of IRA. You can put your general savings into an annuity, and it gets a tax advantage, too. The tax advantage is that as interest is credited to the annuity, it does not get taxed until it is withdrawn.

So whether the money that went into the annuity is traditional IRA, Roth IRA or non-qualified money, you benefit from tax deferral. That means that as interest is credited to the annuity, it does not get taxed until it is withdrawn.

Now we all know that when Congress gives us preferential tax treatment, there are also rules around it. One of the most significant rules affecting annuities — whether the annuity is treated as a traditional IRA, a Roth IRA or non-qualified — is if you take a taxable withdrawal prior to age 59½, that withdrawal will be subject to a 10 percent tax penalty. This penalty is not assessed by the annuity carrier — rather, it is an amount that is computed and paid on your federal income tax return.

So, before putting money into an annuity, be sure you do not plan to take that money out prior to age 59½.

The rationale for this is Congress gave annuities preferential tax treatment to encourage people to use them to save for retirement. So, Congress wants to make sure that’s how they are actually used.

This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice. Please consult with a professional specializing in these areas regarding the applicability of this information to your situation.