#118 - How Are Annuities Taxed? A Simple Guide for Retirement

Eric Blake: Welcome to another episode of the Simply Retirement Podcast. I'm your host, Eric Blake. Joining me, as always, is Wendy McConnell. Wendy, how are you?

Wendy McConnell: I'm good. How are you?

Eric Blake: I'm well, I'm well. So over the last couple of episodes, we've been building this foundation on understanding annuities. And just so we get it out of the way, this is episode three of the series, and episode four is going to be a pop quiz for you, to see how well you've...

Wendy McConnell: You ought to get that red pen out now.

Eric Blake: It's one of those interesting things with annuities, and part of the reason I wanted to do this is that a lot of our audience have gone through emotional transitions. Even retirement itself can be an emotional transition, but if you've gone through a divorce, or if you've been widowed, there are all these different emotional things happening at the same time that you're making these big financial decisions that could be impacting your retirement.

And I've just found, over the many years I've been doing this, that annuities kind of pop up here and there in these situations, because sometimes they have these almost too-good-to-be-true factors, whether it's the guaranteed income or whatever it might be, where annuities sound reasonable in the circumstances. But once you realize, "Hey, I didn't quite understand how this worked," or "It did do what I thought it did, but it actually does this too," that's why I wanted to do this series of episodes, just to provide some clarity around annuities, where they fit, and again, always coming back to making sure we're asking the right questions to decide if this is the right tool or product for our specific retirement plan.

Wendy McConnell: Okay.

Eric Blake: So, in episode one, we went through and answered the very basic question: what is an annuity? We talked about an annuity being a contract with an insurance company designed to provide certain benefits, whether that's guaranteed income, principal protection, or tax deferral. In episode two, we explored the different types of annuities and why someone might choose one over another, depending on what they're trying to accomplish. And in this episode, episode three, we're talking more about the taxation, and this is the part that really does become confusing when we're talking about annuities: that question of how annuities are taxed. It often sounds more complicated than it really is.

But by the end of today's episode, what I want to do is help you understand three simple questions regarding how annuities are taxed, okay? Number one, where did the money come from? What was the source of the money? Two, how do you plan to receive the money back? And then, why are you buying the annuity in the first place? If you can answer those three questions, or at least understand them, it's going to take you a long way in understanding the taxation of annuities. So let's get started, if you're ready to get into another fun tax topic like I am.

Wendy McConnell: Here we go.

Eric Blake: So last week we talked about the difference between an annuity as a concept, as a financial concept, and an annuity as a financial product, and I used the comparison of a restaurant. If you're hungry, you either go to a restaurant, and all you've got to do is pick what you want. That's all you've got to do.

Wendy McConnell: Mm-hmm.

Eric Blake: And that was kind of the financial concept, the payout. One of the questions you had was, "Well, it sounds like an annuity's just a regular, scheduled payment of income," right? And I talked about how, when you think about annuities the way we're referring to them in this episode series, it's as a financial product where you've got to make more decisions. So when you're thinking about a product where you've got to make decisions, it's more like if I were going to still eat, but I'm going to go to the grocery store and pick the stuff that I want. I choose what I want to eat, but now I've got to pick the ingredients. I've got to decide how long it's going to be before I'm going to eat. All these different things, right?

Wendy McConnell: It's going to take longer that way, right?

Eric Blake: It's going to take longer that way. When you think about the grocery store concept, the other thing you have to decide is, of course, not only what the ingredients are and how soon you plan to eat, whether you're cooking for one person or an entire family, but also, we have to think about, "How am I going to pay for all these ingredients?"

Wendy McConnell: Okay.

Eric Blake: Right? How are you going to pay for them? You might use cash, you might use a debit card, you might use a credit card. The groceries didn't change, only the source of the money changed, and that's very similar to purchasing an annuity. Before we talk about how annuities get taxed, the first question is simply, where did the money come from that you're putting into this annuity contract?

So for many retirees, the money comes from a retirement account. That might be an IRA, an old 401(k), or some other type of retirement plan. And for others, the money comes from savings that they've already paid taxes on.

Wendy McConnell: Okay.

Eric Blake: So that might be a savings account, where they've built up a certain amount of money. It might be a brokerage account or an investment account. It might be life insurance proceeds that you've already received. It might be an inheritance. It might even be money from selling some other investment, or maybe you sold your house, or maybe you sold a business. These are all examples of money outside of retirement accounts.

Wendy McConnell: Mm-hmm.

Eric Blake: So the first question, where did the money come from, is the first factor in determining how an annuity is going to be taxed. I want to start with retirement accounts. If you've been saving money into a retirement account for many years, there's a good chance a large portion of your retirement savings is inside an IRA or maybe even an old employer plan, okay? And sometimes people assume that purchasing an annuity inside one of those accounts changes how the money's going to be taxed. In most cases, it doesn't. So here's the easiest way to remember this: it's the investment that changed, not the tax rules. The tax rules generally do not change when we're talking about a retirement account.

I've used this analogy before, but think of a retirement account like an umbrella, okay? The umbrella determines how your money's taxed. In other words, the umbrella is protecting your money from Uncle Sam getting to it, just like it would the rain. So under that umbrella, you choose your investments. You might choose mutual funds, stocks, CDs, or an annuity. Changing the investment doesn't change the umbrella, right? So it's still protecting your money from Uncle Sam, you're just deciding how you want that money to work underneath that umbrella while it's there.

Wendy McConnell: Gotcha.

Eric Blake: So why would somebody choose an annuity inside a retirement account? It's not because of any additional tax benefits, it's because of what they want that investment to do. Maybe they're looking for guaranteed income. Maybe they're looking for principal protection for a portion of their retirement savings. Maybe they're looking for more predictable retirement income.

Wendy McConnell: Mm-hmm.

Eric Blake: Or perhaps they're just trying to reduce the impact of market swings on the money until they get ready to begin spending it. But those are all planning decisions, right? And in fact, in the guide we've been talking about as we've gone through this series, one of the questions I think is really impactful is, why am I considering an annuity in the first place? What is it that I want that money to do before I get ready to use it? So if your goal is guaranteed income, principal protection, or some other planning objective, then you can decide whether an annuity is the right tool to help you accomplish that goal. Because an annuity inside a retirement account follows the same tax rules as your other retirement investments. It's all the same, right? For withdrawals before age 59 and a half, the entire balance may still be subject to a 10% IRS penalty, unless some exception applies. So you don't get around that. Later in retirement, you still have required minimum distributions, or RMDs. Those aren't annuity rules.

Now, there is, and I'm going to create a little confusion here, I hope, an age 59-and-a-half requirement that does apply to annuities, but we're going to talk about that here in just a little bit. In general, an annuity inside a retirement account, it's the retirement account rules that apply. The annuity simply became one of the investments inside the account. So again, if you remember one thing from this part of today's episode, it's that the retirement account determines how your money is taxed. The investment you choose inside that retirement account determines the role it plays inside your retirement plan.

Wendy McConnell: Okay, I got the first part. That it's going to be, if it's already taxed, it's not going to be taxed again, I assume, is what you're saying. But if it hasn't been taxed, it will be taxed like it would for an IRA or a 401(k).

Eric Blake: Right. So let's step back and just do what I said originally, think about where the money's coming from. The money that I'm putting in that annuity, what's the source?

Wendy McConnell: Right. If it's 401(k)...

Eric Blake: Right. So if it's a 401(k) or an IRA, it's the rules of the IRA or the 401(k) that determine the taxation, not the annuity itself.

Wendy McConnell: Okay. So you're still going to have to pay taxes on that when you withdraw it.

Eric Blake: Right. So any money that comes out of it, it doesn't matter what it's sitting in, whether it's an annuity, a mutual fund, or a CD, when it comes out of that IRA, it's going to be fully taxable at whatever your ordinary income tax rate is.

Wendy McConnell: Okay. Now, what's that second thing that you said?

Eric Blake: So the second part is, now, if the money doesn't come from your retirement account, your 401(k) or IRA, it comes from some other bucket of money that's already after-tax.

Wendy McConnell: Mm-hmm.

Eric Blake: Again, maybe a savings account, maybe you sold a real estate property, you sold something, you inherited money, or you received life insurance proceeds. So money that didn't originate from a retirement account in some way. That's what we're going to talk about now, how does that money get taxed?

Wendy McConnell: Okay. Yeah, I'm up to speed now.

Eric Blake: Perfect. So when we think about one of the ways people may purchase an annuity, instead of using money from a retirement account, we purchase the annuity with money you've already paid taxes on. Again, a savings account, a brokerage account, life insurance proceeds, an inheritance, another investment, whatever it might be. Now, those are all examples of money that no longer sits inside a retirement account, or maybe never was in a retirement account. This is a term you might have heard, called a non-qualified annuity.

And not to cause confusion, the word non-qualified simply means, where did that money come from? It did not come from an IRA or a retirement account originally, okay? Because you might also have heard that there are two different basic sources of money: qualified, meaning taxes haven't been paid yet, and non-qualified, meaning it's already been taxed.

Wendy McConnell: Okay, gotcha. Non-qualified, see, it should be the other way around in my mind, you know what I mean? Because non-qualified would make me think no tax, but that's taxed.

Eric Blake: That's where, let's use an example, maybe this will help. So suppose you invest $100,000 into a non-qualified annuity, okay? So I pull the money, $100,000, from my savings account.

Wendy McConnell: Mm-hmm.

Eric Blake: So I'm not paying tax on the $100,000 itself.

Wendy McConnell: Right.

Eric Blake: I might be paying some tax on the interest it's earning, so if it's just sitting in a savings account earning 0.5%, or whatever it might be, you're still going to pay tax on the interest you're earning, but you're not paying tax on the $100,000.

Wendy McConnell: Gotcha.

Eric Blake: Right? So that's non-qualified. I'm paying tax as the money's growing.

Wendy McConnell: Okay.

Eric Blake: Versus qualified, if I have $100,000 in my IRA, I don't pay any tax until I have to start taking money out of there.

Wendy McConnell: And if it gets to be $110,000 over a number of years, you have to pay on all of it.

Eric Blake: Right, exactly. So my example, let's say we put $100,000 into an annuity, and it grows to $130,000, okay? If it's an IRA, when I get ready to take that money out, let's say I'm just going to take it all out. In an IRA, all $130,000 is taxable, right? If I put that same $100,000 from my savings account into an annuity and it grows to $130,000, the $30,000 represents earnings, but I've already paid taxes on the $100,000. So I'm not going to pay tax on that $100,000 again.

Wendy McConnell: Okay.

Eric Blake: Right? So it's only the $30,000 in earnings that I might have to pay tax on. And unlike many investments, where you may owe taxes each year on interest, dividends, and capital gains, the earnings inside the annuity generally continue to grow without being taxed each year. That's what we mean by tax deferral. Eventually I may have to pay tax, but I don't pay tax until I get ready to use the money. The taxes are deferred until I begin taking money out.

Wendy McConnell: Okay.

Eric Blake: Right? And so for many retirees, that means more of their money can remain invested and working for them over time.

Wendy McConnell: So that's different from a Roth IRA, because...

Eric Blake: Roth IRAs are tax-free.

Wendy McConnell: Right.

Eric Blake: Number one, the entire balance is tax-free. Now, let me throw a big wrench into this conversation. Underneath a Roth IRA umbrella, again, think about the umbrella concept, the whole idea of an umbrella is that we're protecting our money from Uncle Sam. However, underneath a Roth IRA umbrella, when I get ready to take it out, it's 100% tax-free, as long as I've met all the guidelines and restrictions, right?

Wendy McConnell: Even on the money that you've earned since it's been in the account. Right, okay.

Eric Blake: But if I wanted those withdrawals from my Roth IRA to be 100% guaranteed income, I could buy an annuity underneath that Roth IRA umbrella.

Wendy McConnell: Okay.

Eric Blake: So it wasn't the annuity that changed or impacted the taxation, it was the Roth umbrella that determined it would be tax-free.

Wendy McConnell: The annuity really never dictates anything when it comes to taxation.

Eric Blake: Not inside the IRA or Roth IRA umbrella. I can buy an annuity outside of a retirement account as well. I can buy an annuity outside of an IRA, outside of a Roth IRA. That's the non-qualified component, right? So that's money I've already paid tax on. If I have $100,000, I can't just say, "Well, I want to put all $100,000 into a Roth IRA," because there are contribution limits, right?

Wendy McConnell: Oh, right, right, right, right. Yep.

Eric Blake: So this year, for example, I can only put in $7,500 if I'm under age 50, or $8,600 if I'm over age 50. That's the most I can put into a Roth IRA.

Wendy McConnell: Mm.

Eric Blake: Right? But if I'm looking for some other source, am I looking for guaranteed income? Am I looking for tax deferral? What is my objective? It always comes back to what I'm trying to accomplish with this money.

Wendy McConnell: But with the non-qualified funding of it, you will have to pay tax on any money that you make from the account.

Eric Blake: True, but not until I get ready to use it. That's tax deferral. That's what we're talking about. With tax deferral, I don't pay tax until I'm ready to use the money.

Wendy McConnell: Okay, gotcha.

Eric Blake: Okay. And obviously, eventually, most people purchase an annuity because they expect to use the money at some point in the future, right? So how that money comes back to you does affect how it gets taxed when we're talking about an after-tax or non-qualified annuity, okay? So let's start with withdrawals. Using the example I used before, suppose your annuity has grown from $100,000 to $130,000. If you begin taking withdrawals before turning the contract into a stream of lifetime income, the tax rules generally treat the earnings as coming out first.

So in our example, withdrawals would generally come first from the $30,000 in earnings. Those earnings are typically taxed at ordinary income rates. But once all the earnings have been withdrawn, those additional withdrawals generally come from my original $100,000 investment. Since I've already paid taxes on that money, those dollars usually aren't going to be taxed again.

Wendy McConnell: Okay.

Eric Blake: Does that make sense? So I put $100,000 in. Over 10 years, it grows to $130,000. I get ready to take that money out. Number one, I have to take the $30,000 out first. That's what we call LIFO, or last-in, first-out, methodology. I've got to take my $30,000 out first, but once I've taken the $30,000 and only my $100,000 is left, I paid tax on the $30,000, but the $100,000 I've already paid tax on comes out basically tax-free.

Wendy McConnell: But if you keep it in there, it's going to keep accumulating.

Eric Blake: It's going to keep accumulating, tax deferral, exactly. So say I ran an illustration and said, "Okay, let me run some projections. If I start with $100,000 and I'm getting some fixed rate of return, and I leave it in there for 10 years, my $100,000 is going to grow to $130,000."

Wendy McConnell: Mm-hmm.

Eric Blake: But if I leave it in there for 20 years, my $100,000 might be $160,000.

Wendy McConnell: Okay.

Eric Blake: If I'm earning that same rate over the 10 years and then over an additional 10 years beyond that, so a total of 20 years. So same illustration, but if I waited 20 years, now my value is $160,000, and I started with $100,000. If I start taking withdrawals, I've got to take the $60,000 out first. It's going to be taxable, most likely as ordinary income. But once I've taken that $60,000 in earnings out, my remaining $100,000 I can take out tax-free, because I've already paid tax on it.

Wendy McConnell: I got you.

Eric Blake: So it's all about deciding how you want this money to work until you get ready to use it, right? And that's simply one of the tax rules associated with taking money out early. Now, back to the 59-and-a-half rule I mentioned for annuities, similar to the 59-and-a-half rule with IRAs. If you're younger than 59 and a half, the taxable portion of a withdrawal from an annuity may be subject to a 10% IRS penalty, again, unless some exception happens to apply. So it's very similar to the IRA rules. Basically, what the IRS has said is, "We will allow you to defer those taxes, but you have to defer them until at least 59 and a half." So, similar to an IRA, 59 and a half applies to an annuity too, but it's only the earnings for the annuity. If it's an after-tax annuity, it's only the earnings that are subject to that 10% penalty, not my original investment.

Wendy McConnell: Right, okay, got it.

Eric Blake: Now let's connect something back to what we discussed in episode two, the term annuitization, which I think was kind of what you thought about annuities in the first place. Because you used the idea of, "Okay, if I win the lottery, I can take the lump sum, or I can take lifetime payouts." The lifetime payouts are basically annuitization. It's the same concept, right?

Wendy McConnell: Okay.

Eric Blake: I've got a lump sum of money that I give the insurance company, and in return they pay me an income for the rest of my life. That's annuitization.

Wendy McConnell: Okay.

Eric Blake: Okay? So that's when I exchange some or all of my annuity value for a series of regular payments. I give them $100,000, and in return, they give me a monthly distribution of some amount, depending on how I structure the contract.

Wendy McConnell: Right.

Eric Blake: That could be over a specific number of years. It might continue over the rest of my life. It might continue over a joint life. If I'm married, I might choose to make sure the income lasts as long as either of us is still alive, right? It depends on what options you choose, how you want to structure that contract. So when that happens with a non-qualified annuity, each payment is generally made up of two parts, okay? Part of that payment represents your original investment, using our $100,000 example. The other part represents earnings, okay? So say my annuity is worth $130,000, and I put $100,000 into it.

Since you've already paid taxes on the original investment, only the earnings portion is generally going to be taxable. There's a term you may have heard called exclusion ratio, and I don't want you to worry about remembering that term.

Wendy McConnell: Good, 'cause I haven't heard that term, so go ahead.

Eric Blake: I just want you to think of it this way. The exclusion ratio is simply the IRS's method of determining how much of each payment I'm receiving is considered a return on my principal, which is generally excluded from taxation, and how much represents earnings, which are going to be taxable.

Wendy McConnell: Okay.

Eric Blake: Okay? And you don't necessarily need to know how that's going to be calculated. But say I put $100,000 in, and I want this to pay me over the next 20 years, and maybe I'm going to receive $1,000 a month. Some portion of that $1,000 a month is going to be tax-free, because that represents what I originally put into it. The other part of that $1,000 is going to be taxed, which represents the calculated earnings on that annuity.

Wendy McConnell: Gotcha.

Eric Blake: Okay?

Wendy McConnell: Yep.

Eric Blake: You got all this, you're going to be ready for the pop quiz next week, right?

Wendy McConnell: No. I'm really trying hard to understand this. You see that.

Eric Blake: And that's why, again, I don't know how great a job I'm doing at trying to explain how annuities work, but just understand, they are complex.

Wendy McConnell: Well, yeah. Yeah, a little.

Eric Blake: And again, my hope, as we wrap it up next week and start talking about some of the features and benefits, guaranteed income riders, guaranteed death benefits, and some of these other terms people have probably heard associated with annuities, is that you'll see they can be really valuable features, as long as you understand what the costs are, what the fees are, and what you're getting out of it. Again, it's always starting with the question I keep coming back to: what do I want this thing to do for me? What am I trying to accomplish? And then, does this annuity feature meet that goal?

Wendy McConnell: Okay.

Eric Blake: That's the biggest thing I would take out of any of this, thinking about what you're trying to accomplish. Working with retirees a lot, especially if somebody's really disciplined about savings over their career, they're really good at saving money, but they're not always good at spending money when they actually get to retirement, as crazy as that sounds, right? So sometimes you say, "Well, I just can't spend. I don't want to spend. I don't want to take any chances of losing it." But sometimes you might think, "Well, okay, what if I had guaranteed income? How would that change my mindset? How would that change my emotions about spending money?"

And if you said, "Well, you know what? If I actually had a certain amount of guaranteed income, I would probably feel much better about spending it, if I knew it wasn't going to run out," that might be a situation where we think about incorporating an annuity into our strategy, our income strategy. But it still comes back to understanding what your objective is, what you're trying to accomplish with this particular strategy, product, or solution.

Wendy McConnell: Okay. Are you going to talk about the fees next week?

Eric Blake: Yes, okay. We're going to tie it all together, questions to ask, features, benefits, and some of the other considerations you want to think about with annuities. So as we get ready to wrap up today's conversation, back to the three questions we started with. First, where did the money come from? If it came from a retirement account, the retirement account generally determines how the money gets taxed. If it came from money outside a retirement account, that's what we call a non-qualified annuity, and it's the IRS rules around annuities that determine the taxation. The earnings must come out first if you're taking withdrawals. Once you reach your principal, that becomes tax-free. If you're taking guaranteed payments, it's going to be split between principal, what you put into it, and the calculated earnings, okay?

So that's the second question: how do we plan to receive the money back? Occasional withdrawals and lifetime income payments may be taxed differently, because the money is coming back to you in different ways, okay? And then finally, coming back to our key point: why are you buying the annuity in the first place? Taxes are very important, but taxes alone shouldn't determine whether an annuity belongs in your retirement plan. The planning objective always comes first. The tax rules simply help you understand how that decision affects you individually.

Wendy McConnell: All right, I'm looking forward to hearing about the fee structure. I want to know how much all this is going to cost me.

Eric Blake: Well, again, it's always a trade-off. We'll touch on this next time, but there's nothing ever inherently wrong with fees. It's about whether I'm getting the value out of paying whatever that fee might be. Whatever your priority is, a guaranteed death benefit, guaranteed income, principal protection, whatever your objective is, there's nothing wrong with paying fees if it helps you meet those objectives.

Wendy McConnell: Okay.

Eric Blake: Right.

Wendy McConnell: Yep.

Eric Blake: So hopefully this conversation made annuity taxation just a little bit easier to understand. And again, I know it's complicated, but be sure to follow the show to tune into our next episode, and hopefully we'll bring everything together for you. We'll talk about the potential fees associated with annuities, some of the optional riders and features that annuities may provide, and most importantly, questions to ask before purchasing or even replacing an existing annuity, and how you decide whether an annuity truly fits within your overall retirement plan.

Don't forget to download the free guide we've been talking about, Does an Annuity Fit Within My Financial Plan? You can find all the links and resources for this episode at thesimplyretirementpodcast.com. And until next time, please remember, retirement is not the end of the road. It's the start of a new journey.