The IRS taxes the payments you receive from an income annuity. The way the payments are taxed depends on what type of funds you use when you buy the annuity.

Annuities bought with money from tax-deferred accounts

If you buy an income annuity by rolling over money from a tax-deductible traditional IRA or employer-sponsored retirement plan, such as a 401(k) or 403(b), no taxes are due at the time of the rollover.

However, as you receive payments the total amount of each payment is taxed at your ordinary income tax rate. That’s because the money you used to buy the annuity hasn’t been taxed yet. So when you’re figuring how much income you need to meet your expenses, keep in mind that you’ll have to pay taxes with part of your payments.

If you made nondeductible contributions to your traditional IRA, or after-tax contributions to your 401(k), however, part of your payments aren’t taxable.

One of the advantages of buying an income annuity with money from a traditional IRA or employer retirement plan is that it’s a convenient way to meet the IRS required minimum distribution rules.

These rules require you to start taking at least annual minimum distributions from tax-deferred retirement accounts at age 70½. Lifetime income payments from an income annuity automatically meet these rules.

Annuities bought with money from taxable accounts

If you buy an income annuity with money from a taxable account, only the earnings portion of each payment is taxable. You already paid taxes on the money you used to buy the annuity, so that portion is considered a tax-free return of your purchase payment.

Your earnings are taxed as ordinary income and the portion that’s not taxed is figured by an IRS exclusion ratio formula. Once your total purchase payment has been returned, the entire amount of each payment comes from earnings and is therefore fully taxable.

If you have both tax-deferred and taxable accounts

If you have retirement savings in both taxable accounts and tax-deferred retirement plans, such as a traditional IRA or 401(k) or 403(b) plan, you may want to consider buying an annuity with your retirement plan money.

That’s because income payments from an annuity and withdrawals from tax-deferred retirement plans are both taxed as ordinary income. In contrast, gains on your taxable accounts are taxed at the more favorable capital gains tax rate.

Moreover, if you leave taxable accounts to your heirs the cost basis of any appreciated assets in these accounts is stepped-up to the fair market value on the date of your death (or the alternate valuation date, if less). So no tax is ever due on the gains that occurred prior to your death.

(At least until 2010, when this so-called step-up basis is scheduled to be limited. These limits are only for the year 2010, however, since the entire Tax Act of 2001 expires in 2011, unless future legislation is enacted before then.)

Therefore, you may want to leave any money you have in taxable accounts where it is. That way you won’t turn earnings that are taxed as capital gains into earnings that are taxed as ordinary income.

Article is for educational purposes only and is not intended to provide specific tax or legal advice. For answers to tax questions, please see your tax professional. For legal questions, consult an attorney.

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