If you bought your annuity with pretax money from an IRA or a 401(k), you will have to pay income taxes on the payments that have not already been taxed when you sell your annuity payments. And any earnings on your annuity funds will be considered taxable as income. The best way to determine how much of your money is taxable is to ask the insurance company that holds your annuity. It’s also wise to consult a tax advisor regarding your tax burden before selling your annuity.
Your tax obligation when you sell your annuity payments is the same it would be if you received regular payments or made a withdrawal from the annuity. To understand that, it’s helpful to review how annuities are taxed.
When Are Annuities Taxable?
The main tax benefit of most annuities is that they are tax deferred. That means the taxes are not paid until the funds are withdrawn or paid to you.
But not all annuity funds are taxed equally. The main factor that determines how the money from an annuity is taxed is whether the funds that were used to purchase it had already had taxes taken out. If the answer is yes, then the product is categorized as a non-qualified annuity.
With a non-qualified annuity, only the earnings are taxable. So when you receive money from a non-qualified annuity, you pay income taxes on any financial gains above the initial cost — the principle — of the annuity.
So, for example, let’s say you used money from your savings to purchase an annuity for $100,000. Over time, the value of the annuity grows to $120,000. In this case, since your savings came from your paycheck, on which you’ve already paid income tax, the taxable portion of your annuity will be just $20,000.
If the annuity is one of your IRA investment elections or was purchased with a tax-advantaged retirement account, such as a 401(k), then all withdrawals and payouts will be taxed as ordinary income. These are considered qualified annuities.
Qualified annuities cannot be sold because the tax liability attached to the money can’t be transferred.
Taxes When You Sell
When you sell your annuity payments, they will be taxed the same as if you’d received an ordinary annuity withdrawal.
But annuities held in qualified retirement accounts can’t be sold to a third party. Such transactions make up the secondary market — similar to the stock market but specific to the sale of annuities.
If you sell your total annuity contract, the amount in the annuity that exceeds what you paid for the annuity is considered taxable as ordinary income. The money you may have spent on riders is not considered part of your initial investment, and therefore is not excluded from income tax.
In addition, if you sell your annuity payments before reaching the age of 59 1/2, you will face a tax penalty of 10 percent.
Implications for Annuity Transfers
Annuity owners who want to transfer ownership to someone else, such as another family member or trusted friend, will be subject to income taxes on anything earned by the annuity at the time of the transfer.
The only exceptions are when ownership is transferred to a current spouse or to a former spouse in a divorce settlement.
Annuity transfers to friends or family members are treated the same for tax purposes as selling your annuity.
Annuity Gifts
There may also be federal gift taxes that apply to transfers made as gifts. The gift-tax rate ranges from 18% to 40%. In general, the person who gives the gift is responsible for paying this tax. The Tax Code provides a lifetime exemption (currently $12.92 million per person in 2023). As long as your total lifetime gifts and estate are below this amount, you don’t have to pay taxes when you gift an annuity.
However, the annual exclusion amount for gifts, according to the IRS, is $17,000 for 2023. If you transfer an annuity worth more than $17,000, you must file a gift tax return, even though no tax is due.
The exclusion applies to all gifts given to the same person or entity in a single tax year. In other words, you may give anyone a total of $15,000 worth of gifts in a single year without having to pay a gift tax.
Some states — specifically Connecticut and Minnesota — also collect gift taxes. You should check the laws in your state as state laws may change.
