Tax Requirement of Early Withdrawal of an Annuity

Withdrawing from your annuity can create a headache at tax time.
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Financial emergencies are one of the great enemies of retirement planning. Even if you've built an emergency fund and have done everything else you're supposed to, life can sometimes hit you with a budgetary "perfect storm." When those occasions arise, you might find it necessary to draw some funds from your annuities or other retirement savings vehicles. It's a viable way to stay afloat when things are rough, but you'll need to be wary of the tax implications.

Annuity Refresher

Before discussing the taxation of annuities, it's worth taking a moment to review how they work. An annuity is basically an inside-out life insurance policy: Instead of paying big bucks when you die, it makes smaller payments for as long as you live. You can buy one outright with a lump sum, or make regular premium payments over a period of years. If you own an annuity now, it's probably the second type, called a "deferred" annuity because you won't take income from it until you reach retirement age. That's the plan, anyway. If you need to withdraw money during your working years, things get a bit complicated.

Contributions vs. Earnings

Many owners are surprised to learn that their annuity contains two distinctly different kinds of money. The first kind is your principal, the amount you've paid into the plan through your contributions. The second kind is the plan's earnings or investment gains. It's important to understand the distinction, because the IRS treats those two kinds of money differently. Your contributions are usually made with after-tax dollars, so they're not taxable again when you take them out of the plan. However, your gains are fully taxable.

Taxation of Withdrawals

When you withdraw money from an annuity for any purpose, the IRS considers you to be withdrawing from your earnings first. So, if you've contributed $100,000 and the annuity contains $150,000, the first $50,000 you withdraw is earnings and fully taxable. Worse, it's considered ordinary income and is taxed at the highest rate. In contrast, if you sell shares of a stock, your profit is considered a capital gain and is taxed at a significantly lower rate. If you make a withdrawal from an annuity before you reach the age of 59 1/2, the news is worse: You'll also be liable for a further 10 percent penalty on the taxable amount.

Further Considerations

Depending on your personal tax rate, withdrawing from your annuity can trigger a substantial dollar amount in penalties. You might also have to pay surrender fees or administrative fees to the insurer carrying your annuity, although those decrease over time as the tax burden increases. Your insurer can help you calculate the costs of making a withdrawal. Depending on your needs, you might be better served by borrowing. Annuities often allow you to borrow up to half of their value and repay on a set schedule. You can also use your annuity as collateral and borrow from a third-party lender.

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