How to Calculate Taxable Income on an Annuity

How do you calculate taxable income on an annuity? Boy, what a question, huh? That's a barn burner, as they say in the South. Hi, I'm Stan The Annuity Man, America's Annuity Agent, licensed in all 50 states. Today, we're going to talk about the taxation of annuities. It’s essential for you to understand this, so I encourage you to go to The Annuity Man, where you can get my books for free and with no obligation. Just sign up on the site. You can also use our proprietary calculators to run quotes on your terms and timeframe.

Understanding Taxable Income on Annuities

What is the taxable portion of an annuity? How are withdrawals from annuities taxed? How is annuity income reported to the IRS? When discussing calculating taxable income on annuities, I assume you’ve got a life outside of taxes and read the IRS tax code. That's why you’re here—to get help with that.

We’ll cover all the details, from LIFO and the exclusion ratio to all the annuity terms, but I’ll break them down into plain English. Let’s get started.

Two Types of Annuities 

Calculating taxable income on an annuity depends on the annuity type. There are two main types of annuities when you talk about income:

1. Annuitization Products: These include Single Premium Immediate Annuities (SPIAs), Deferred Income Annuities (DIAs), and Qualified Longevity Annuity Contracts (QLACs). Think of these as irrevocable income streams—once you turn them on, they flow like water from a faucet.
2. Income Riders: These can be attached to deferred annuities, like Indexed Annuities or Variable Annuities. They’re a separate calculation and are typically withdrawal products, where you’re withdrawing income for life, but it's not annuitized.

Taxation of Annuitized Products

Let’s start with annuitization products like SPIAs, DIAs, and QLACs. These products are designed to give you income for life, and the income stream is a combination of return of principal plus interest. Here's how it works:

• Non-IRA Accounts (Non-Qualified): You’ll pay taxes on the interest portion of the withdrawals, but once the principal is exhausted, all further income is taxable.
• IRAs: All withdrawals are taxable because they are tax-deferred accounts.

Taxation of Income Riders

Next, let’s talk about Income Riders. When you add an income rider to a Deferred Annuity, it’s a withdrawal product, not an annuitized product. For Income Riders, withdrawals are taxed LIFO (Last In, First Out). This means:

• The first portion of your withdrawal will be taxed as income, and you’ll pay taxes on the gains first.
• Once you’ve withdrawn your principal, the income continues, but no further taxes are due.
• Once the account hits zero, all subsequent income is taxable.

Understanding the Tax Bracket

When you’re calculating the taxable income on your annuity, the tax rate depends on your tax bracket. You'll pay less tax if you’re in a lower tax bracket. If you're in a higher tax bracket, you’ll pay more. It’s simple, right?

Also, all annuity income is reported as ordinary income, and the IRS will issue a 1099 for your annuity income. This is important to understand when planning your taxes.

Takeaway: Always Consult a Tax Professional

Now, here's something very important: Never take tax advice from an agent or advisor unless they’re a CPA or a tax lawyer. The bottom line is only to take tax advice from a tax professional.

Conclusion

So, wasn't that fun? You’ve learned how taxable income works on annuities. But at the end of the day, you’ll want to talk to your tax advisor, CPA, and The Annuity Man team. I encourage you to visit The Annuity Man to run your own quotes, get my books for free, and schedule a call with us.