Fully Taxable Payments
Annuity payments you receive are fully taxable as ordinary income if you use pretax money to buy your plan. For example, you can hold an annuity in a 401(k) plan or tax deductible IRA, both of which are funded with pretax income. Holding an annuity in a tax advantaged retirement plan is typically not financially advantageous, since 401(k)s, IRAs and similar accounts already offer tax deferral and annuities can carry high fees.
Partially Taxable Payments
When you buy an annuity with after-tax income, payments you receive from the annuity are partially taxable. The government doesn’t make you pay income taxes twice on the same money, so the amount of a withdrawal that represents a return of your original after-tax contributions is not taxed. On the other hand, withdrawals of investment earnings are still taxed at your ordinary income tax rate.
Tax on Early Distributions
Investment accounts with tax deferral are designed to help people save money for retirement, so the government places restrictions on withdrawals made before retirement age. If you take money out of an annuity before the age of 59 1/2, the withdrawal is an early distribution and is subject to a 10-percent early withdrawal tax. The 10-percent penalty only applies to the taxable portion of an annuity payment.
The Internal Revenue Service offers exceptions to the 10-percent early withdrawal penalty in certain special situations. Early distributions from your annuity are not subject to the penalty if you are disabled or pass away before you withdraw all the money from your account. Withdrawals are not penalized if you receive funds as a series of equal periodic payments for your life or based on your life expectancy
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