Are annuities tax deferred under current taxation regulations?

The tax treatment of annuities is governed by the IRC and it is contingent on whether the annuities are qualified or non-qualified.

Both annuity types allow the interest to grow on a tax-deferred basis during the accumulation period, but once the payout period starts and distribution of funds begins, the interest portion is taxable as ordinary income.

Taxation of Nonqualified Annuities

These refer to individual annuities purchased from a commercial insurance company and that does not meet the IRC requirements for qualified employer retirement plans. This is how nonqualified annuity taxation works:

• Nonqualified annuity premiums are paid with after-tax dollars and are thus not income-tax deductible.
• The investment income is tax-deferred until the funds are distributed or withdrawn from.
• After distribution, the funds that are taxable are taxed as ordinary income.
• If interest is withdrawn from before age 59 and a half, there is a 10 percent penalty tax.
• If annuitization is chosen, the insurer calculates an exclusion ratio by dividing the investment in the contract by the expected return to determine the taxable and nontaxable portions of the annuity payments. Thus, only a portion of each payment is subject to tax until the owner has received the total of their contributions back. Every payment the owner receives after that is entirely taxable as ordinary income.
• The expected return is calculated by multiplying the payments the annuitant will receive every year by the life expectancy of the annuitant.

Taxation of Qualified Annuities

• Under qualified annuities, the accumulations of investment, regardless of the nature of the interest rate they are based on, are not taxable.
• There is a 10 percent penalty if the contract owner withdraws from the accumulated cash before they have reached the age of 59 and a half. Every penny withdrawn or otherwise distributed is taxed as ordinary income.

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