Taxes on Annuity Benefits

Understanding how the IRS taxes annuity benefits requires understanding the two ways an annuity can be structured: qualified or non-qualified. Qualified annuities are retirement savings plans either obtained through employment or opened as an IRA. All assets in qualified plans are tax-deferred. Non-qualified assets are supplemental retirement accounts opened through insurance companies where only the earnings get tax deferral.

Qualified Plan Distributions

Distributions from a qualified annuity plan may be taken starting at age 59 1/2 without being assessed an early withdrawal penalty of 10 percent. The entire distribution is added to the annual adjusted gross income of the annuity plan owner. In the year the annuity plan owner turns 70 1/2, a required minimum distribution must be taken annually and is added to income. There is a 50 percent penalty for failing to take this distribution. A person may take a hardship distribution or use part of the qualified plan assets for college tuition or a home purchase without penalty under IRS defined circumstances.

Non-qualified annuities also require investors to reach age 59 1/2 before taking withdrawals from the annuity to prevent a 10 percent penalty. The earnings on the withdrawal are added to income. All non-qualified annuities use the LIFO method of accounting which means that the last money in is the first money withdrawn. This means all earnings will be taxed prior to taking principal out. There is no minimum distribution required at age 70 1/2, nor are hardship or other withdrawal exemptions permitted.

The amount in an annuity, whether it is qualified or non-qualified, is added to the taxable estate and taxed under the federal estate transfer tax rules. Additionally, the beneficiary must add the distribution to his annual adjusted gross income. The beneficiary can mitigate some of the income taxes by stretching the payments over time. A qualified plan may be taken as a lump sum, over five years or assumed as a "beneficiary IRA" to be paid over the beneficiary's lifetime. A non-qualified annuity can be paid as a lump sum or over five years. The taxes are owed for the year the money is taken out.