If you own an annuity or are considering investing in one, you must familiarize yourself with the potential tax consequences surrounding deposits and withdrawals. Annuities are available from countless insurance companies, and each product has its own features and benefits. However, regardless of the contract provider and the specific type of annuity, the same rules regarding taxation of contributions and distributions apply to all of the products .
Money deposited into qualified annuities entitles you to an income tax deduction. The value of the account grows tax-deferred until you withdraw it or close the account. When you actually take possession of the money, your taxable earnings for that year are increased by the amount of the withdrawal. If your account value is large enough, your earnings could be increased to a higher tax bracket.
Money deposited into non-qualified annuities does not entitle you to an income tax deduction. However, money accumulates tax-deferred until you withdraw it or cancel your account. The result is a combination of taxed and untaxed money in the same account. If you close the annuity, only the portion considered growth is subject to income taxes. Your original contributions, on which taxes were already paid, is simply returned to you without additional liability. The growth in the annuity account is added to your taxable earnings for that year.
If you are under age 59 -1/2 when you close your annuity account, the untaxed portions are added to your taxable income for that year, in addition to a 10-percent penalty fee. The fee is assessed on only the untaxed portion of the the account. If your annuity is in a qualified account, 10 percent of the entire balance is added to your taxes. However, if your annuity is non-qualified, only the growth will generate the 10-percent penalty.
Aside from ordinary income taxes due and the potential penalty for early withdrawals, your annuity may be subject to surrender charges. If you close your annuity account too early, the insurance company may penalize you. Every annuity contract is different, and the length of the surrender schedule differs between carriers and products. The most common surrender charge duration is seven years, which means closing your annuity within the first seven years results in a penalty imposed by the life insurance company. These penalties typically range from 4 to 9 percent but may be higher or lower depending on your specific contract. Surrender charges are separate and apart from any taxes or penalties imposed by the IRS.