When Can I Make a Tax-Free Withdrawal From My IRA Variable Annuity?

Variable annuities are contracts in which you deposit and invest money during an accumulation phase and receive periodic or lump sum payments during a payout phase. These contracts normally pay a death benefit as well. The amount you receive depends on your contributions, fees and investment returns. Variable annuities are “qualified” if they reside in an IRA or employer retirement plan. Normally, you contribute pre-tax dollars -- the contributions are tax-deductible -- into a qualified annuity, although certain circumstances permit you to contribute post-tax dollars. Any post-tax contributions add to your annuity’s cost basis, which normally isn't taxable when withdrawn after age 59 1/2.

Your taxes on IRA annuity withdrawals depend on the account’s cost basis. If you have a Roth IRA, all of your contributions are post-tax and therefore form a cost basis. You don’t fork over taxes on Roth IRA withdrawals if you follow the rules. Normally, contributions to a traditional IRA or employee plan are pre-tax and therefore don’t create a cost basis. These are taxable when withdrawn. However, you might form a cost basis on part of your traditional IRA through nondeductible contributions and rollovers. If your traditional IRA has a cost basis, you must figure the basis as a percentage of the IRA’s value and prorate all withdrawals between the cost basis and the remainder. Only the prorated cost basis portion of a withdrawal is tax-free.

Withdrawals of contributions from Roth IRAs are always tax-free. However, you will have to shell out taxes, and possibly penalties, for early withdrawal of investment earnings. The Internal Revenue Service will slap you with taxes and a 10 percent penalty on any earnings you siphon off during the five years following your initial contribution to the Roth IRA. You also must hand over taxes and penalties if your withdraw earnings before age 59 1/2, although the IRS grants certain penalty exceptions. If you avoid early withdrawals, you don’t have to pay taxes on distributions from a Roth IRA, including money tapped from a variable annuity held in the account.

You must pay taxes on withdrawals from a variable annuity held in your traditional IRA, except for any portion representing the cost basis. You form a cost basis if you make contributions in years in which you or your spouse also belong to an employer plan and your income exceeds certain limits. Another source of IRA cost basis is a rollover from a traditional employer account that has a cost basis. This doesn't include designated Roth employer accounts, which you can’t roll into a traditional IRA. If you make taxable withdrawals before age 59 1/2, you might have to cough up the 10 percent early withdrawal penalty.

OK, you've owned a Roth IRA for more than five years and are older than 59 1/2. Uncle Sam won’t be collecting taxes on annuity withdrawals, but your contract provider might not be as accommodating. Surrender fees usually apply for seven or more years from the start of an annuity contract. Annuity providers might confiscate surrender fees of 15 percent or more for withdrawals during the first few years of the contract. The percentage slowly drops each year until the surrender period ends. Some contracts permit you to withdraw a small percentage of your contract value each year without hitting you up for surrender fees.