There are different types of annuities and they can each be held to different taxation rules. When someone obtains or purchases an annuity, they are often confused about what to expect from the IRS. With such complexities involving taxation, many annuitants make the wise decision to consult with a tax professional, so they can be sure they are paying appropriately.
Although annuities are meant to offer protection against income taxes, it is essential individuals understand holding an annuity does not necessarily mean they will be able to receive payments or withdraw money without any tax implications.
It is important individuals realize, while annuities are meant to offer tax deferment, this does not mean the annuity is entirely tax-free. The main benefit of an annuity is the ability of the account to gain interest while remaining tax-free until funds are withdrawn.
Taxes will not be due on an annuity until payments are received or a lump sum is withdrawn. Withdrawals and any lump sum distributions are considered income by the Internal Revenue Service and they will be taxed as such. These withdrawals are not taxed at the lower capital gains tax rate.
Qualified or Non-Qualified?
When it comes to income taxes being owed on annuity payments or withdrawals, one of the most important things to consider is the type of annuity. A qualified annuity means the money used to open the account has never been taxed, such as with a 401(k). Those receiving payments or withdrawals from a qualified account are going to be taxed as if they received income.
Non-qualified annuities are annuities that were purchased after taxes were already taken out. The amount of taxes that are owed on this type of annuity will depend on the exclusion ratio. To figure the exclusion ratio, one must know the principal amount that was used to purchase the annuity, the amount of time the annuity has been held by the annuitant, and the interest earnings that have accrued since opening the annuity.
Get Help From a Tax Professional
When in doubt, it is wise for annuitants to meet with a tax professional, so they can discover what type of taxation they can expect from their payments or withdrawals. As long as the money stays in the account, the IRS will not tax the amount.
If an individual begins receiving payments or withdrawals, it is essential they understand their tax implications, so they can plan accordingly. Without proper knowledge, individuals could end up neglecting to properly report their annuity earnings and be in trouble with the IRS. A failure to report these earnings could result in hefty penalties.
Annuity holders need to make sure they are aware of any tax laws that may affect their ability to withdraw from their annuity account. It is wise for a person to make sure they understand the tax implications before they begin making any withdraws, so they will not get any unwanted surprises when it comes time to file their income tax return for that year.