For decades, Florida has been a destination for retirees. In 2021 alone, the Sunshine State’s glistening shores and warmer climates welcomed over 78,000 older adults—three times as many retirees that moved to Arizona, the second-ranked state. However, for many, Florida’s true allure isn’t just its sandy beaches and endless sunshine; it’s the state’s status as a tax haven.
With no state income, inheritance, or estate tax, Florida seems like a retiree’s tax paradise. But what about financial products specifically designed for retirement, like annuities? You may wonder: how are annuities taxed at the state and federal levels? Here’s what to know.
Qualified vs. Nonqualified Annuities
Annuities are typically either qualified or nonqualified. Qualified annuities are funded with pretax money, such as retirement plan contributions, while nonqualified annuities use after-tax dollars from a savings account or another individual account. Each is taxed differently.
How Qualified Annuities Are Taxed
Earnings from qualified annuities are tax-deferred until you take withdrawals. Because qualified annuities are funded with pretax money and grow on a tax-deferred basis, you pay ordinary income tax on withdrawals.
For instance, if you receive 12 monthly payments of $6,000, you pay income tax on the total distribution. The taxes you owe on your qualified annuity withdrawal are based on your tax bracket when you receive the distribution.
How Nonqualified Annuities Are Taxed
Earnings in a nonqualified annuity are tax-deferred until you take withdrawals. While withdrawals of your principal aren’t taxed, you pay taxes on any capital gains, interest, or appreciation of the principal balance.
However, you have no control over the ratio of principal versus earnings you withdraw. Instead, the annuity’s taxable earnings pay first, which means you pay taxes on the entire withdrawal amount until all earnings are disbursed.
Lump-Sum Payments
The earnings are disbursed first if you have a lump-sum payment. When the taxable earnings are exhausted, you can start drawing from your tax-free principal. You can reduce your tax liability by converting the balance to a lifetime income stream with a different tax treatment.
Streams of Payments
With nonqualified annuities, every payment includes a tax-free principal and taxable earnings. In other words, every disbursement in a stream of payments is partially taxable.
For instance, say you receive $6,000 monthly, and $5,000 is the principal. This $5,000 wouldn’t be taxed, but the remaining $1,000 would be taxable because it derives from earnings. However, the total amount may be taxable if you outlive your statistical life expectancy or exhaust all principal.
Understanding the Exclusion Ratio for Nonqualified Annuity Taxation
Your exclusion ratio helps you calculate the percentage of each payment that’s nontaxable principal versus taxable earnings. It remains the same for the annuity’s entire life.
Here’s how it works:
1. Quantify the Expected Return
What’s the total amount you wish to receive from your annuity over its lifetime?
2. Determine Your Investment
What’s the total amount of after-tax money you’ve put in the annuity?
3. Calculate the Exclusion Ratio
Divide your total after-tax investment by the expected return. The resulting number is your exclusion ratio.
4. Apply Your Exclusion Ratio to Annuity Payments
To apply your calculated exclusion ratio, multiply it by the annuity payment amount. This shows you the dollar amount of every payment representing your tax-free principal. The remaining balance is taxable earnings.
For example, say you invested $50,000 in a nonqualified annuity and expect to receive $100,000 over its lifetime. Your exclusion ratio would be 50% ($50,000 / $100,000). If your monthly annuity payment is $1,000, then $500 wouldn’t be taxed and $500 would be taxable.
How Are Annuities Taxed in an Inheritance?
If you inherit an annuity, the tax implications can vary based on the type of annuity and your relationship with the original owner. The distributions are taxed as ordinary income if you inherit a qualified annuity. You can take a lump sum or space the distributions over several years.
Distributions from a nonqualified annuity follow the exclusion ratio. Every distribution is partially tax-free principal and taxable earnings. To determine tax liability, use the original owner’s exclusion ratio.
In addition to income tax, the annuity may be subject to an estate tax if the value exceeds the 2024 threshold of $13.61 million. You may also owe an inheritance tax if you live in one of the six states that assess inheritance taxes.
While inherited annuities can pose some challenges for beneficiaries, the basic rule is that taxes are due on all monies that haven’t been taxed yet.
Managing the Impact of Taxation
Though you typically can’t avoid taxes on annuity payments, you can use strategies to minimize the impact.
Consider Your Location
Where you live can play a crucial role in your annuity tax liability. When selecting your retirement location, consider the state’s tax laws on annuity income. Some states, like Florida, offer more favorable tax treatment than others.
Time Your Withdrawals
Timing is everything when managing and reducing your annuity’s tax liability. Spreading out your withdrawals can help. Taking smaller distributions over multiple years, rather than a lump sum, can help avoid pushing you into a higher tax bracket in a single year. You can also consider partial withdrawals to manage your taxable income and stay in a lower tax bracket.
Select the Right Type of Annuity
If you plan on being in a higher tax bracket in retirement, a nonqualified annuity may offer benefits because only the earnings are subject to taxation. On the other hand, a qualified annuity may be more suitable if you plan on being in a lower tax bracket in retirement because you defer taxation until withdrawal.
Navigating the Tax Code
Don’t leave your retirement income to chance. Consider if annuities can fit into your retirement strategy and help build your financial future.
If you have any questions about how annuities are taxed, don’t hesitate to contact a Bankers Life representative. Our knowledgeable financial professionals can help you navigate the intricacies of selecting an annuity and understanding how it’s taxed.
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