An annuity is a type of insurance. Instead of paying out when your car crashes or your house burns, the annuity pays you money in retirement -- usually as a fixed amount per month. You can invest in an annuity yourself, but your employer may also help you buy an annuity as a fringe benefit. When you withdraw money from the annuity, some of it will probably be taxable.
The Tax-Free Part
When you or your employer contribute to an annuity, the insurer invests the money. Like a 401(k) or individual retirement account, earnings in an annuity accumulate tax free until you tap the account. When the time comes to take the cash out, withdrawing the money you contributed yourself is tax free. Withdrawn earnings are taxable, and your employer's contributions are taxable too. If your employer paid all the costs of the annuity, everything you withdraw is taxable income.
Figuring It out
Internal Revenue Service Publication 575 has the formulas for figuring how much of each withdrawal is taxable. The standard method is to divide your total contributions by the number of monthly payments the IRS expects you'll receive. If you're under 55, for instance, the IRS anticipates 360 monthly payments. If you contributed, say, $36,000 to the plan, dividing that by 360 gives you $100. That much of each payment is tax free. The specific formula for your annuity may be different.
The government lets your annuity earn money tax free to contribute toward your retirement. If you take money out of the annuity before you turn 59 1/2, the IRS will hit you with an extra 10 percent penalty for early withdrawal. This only applies to taxable withdrawals; the part coming from your original contributions is tax free and penalty free even if you tap it early. The insurer or your workplace plan may impose a penalty, though. Some penalties are as high as 20 percent, so check before you withdraw.
When you withdraw money from an annuity, the insurer will usually withhold some for taxes, just like your employer withholds from your wages. Only the taxable part is affected by the withholding. You can choose to skip withholding, but then you have to pay estimated taxes. With estimated taxes, you calculate how much you expect to owe, then send it to the IRS in the form of four payments per year.
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