When I take annuity payments, how will they be taxed?

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Q. I am 66 and I have two fixed annuities for life with a rider attached. I plan to start my monthly payments for life at age 71. I’m confused about how the payments are taxed. I’ve heard that for federal taxes, it goes by the “last in, first out” rule, meaning I would be taxed on the total monthly payment until all the interest and gains until I was 84, and then it would be tax-free. Is that true?
— Taxed enough

A. The taxation of your specific annuities depends on a couple of assumptions.

We’re going to assume that your fixed annuities were funded with after-tax money, meaning that they’re not funded with an IRA or a pension plan. We’re also going to assume that the rider you mentioned means you’re not “annuitizing” the balance or taking payments, but instead the rider will pay you a certain percentage of the account balance for the rest of your life.

Based on the above assumptions, you will indeed pay federal income tax on the annuity payments until you have recovered all of the earnings in the account, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

Hook offered this example. Let’s say you invested $100,000 and the account is now worth $150,000. You will pay income tax on the first $50,000 of payments, representing the earnings in the account. Once you have received $50,000 in payments, the balance of the annuity payments will be tax-free to you, Hook said.

This is different than if you had “annuitized “ the balance.

“If you would have done that then a portion of each payment would have been considered a return of your original investment and a portion would have been considered earnings,” Hook said. “This would be the case until you have been paid out all of what you originally contributed, at which point future payments would be 100% taxed.”

Your rider probably specifies a fixed percentage to be paid to you which is not directly tied to your specific age, Hook said. For example, the rider may say to pay you 5% of the balance of the annuity for your life. Also, if there are funds left over after you die, your beneficiary would receive the amount remaining, Hook said.

“Annuitization, on the other hand, is a payment usually based on your age — and your spouse’s age if a joint annuity,” Hook said. “In its simplest form, once the annuitant dies, there is nothing left over for heirs.”

Though, Hook said, there are some forms of annuity payments that do allow for a limited payment to a beneficiary.

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This story was originally published on Jan. 26, 2021.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.