Currently, because the federal funds interest rate is rather low, annuities are not very popular investment options. They have their time and place, and there are still a lot of people that like to use them. But it is important to know how they will be taxed before you jump right in and start to accumulate money with an annuity. Your accountant in Billings, Montana will certainly help you with these taxes, but this way you can be prepared before you enter his office.

Phases of an Annuity

Before talking about the taxes, we need to understand the different phases of the annuity. Since this is a complex financial product, it has a lot of different working parts. There are essentially two phases to an annuity.

The accumulation phase is when you are still contributing money into the account. This can be done by moving over a few hundred dollars per month, or in larger sums at the end of every year, or even in lump sums. In fact, many people opt for a very short accumulation phase, and they move their entire pension or 401(k) into an annuity when they retire.

The annuitization phase, more commonly called the payout phase, is after you are done putting money into the account, and now you are pulling it out. Based on your age and life expectancy (and a variety of other factors) the annuity company will pay you a set amount every month for the rest of your life (or until the specified period has ended). This is where taxes can be a little tricky.

Taxation of an Annuity

Annuities can be held within an IRA, or they can be considered non-qualified accounts. To make matters simpler, we will assume we are dealing with a non-qualified annuity.

Over your working career, you put money into this annuity. That money will have already been taxed. However, there will be growth in the annuity that is not taxed until you pull the money out. But there is no way to designate which money is going in, and which is coming out, so some special accounting needs to be done.

Let’s suppose that you put in $150,000 into your annuity, and when you annuitize it, the value is $200,000. That means 75% of the money has already been subjected to tax. So when the money comes out of the annuity, only 25% is subject to further taxation.

The concept is pretty simple, but it can get even more complicated when it comes time. Instead of worrying about what will be taxed and what will not be taxed, talk with Mike, an accountant in Billings, Montana. He has the knowledge needed to prepare your taxes no matter where the income comes from.

Practical Taxes is a full service accounting firm in Billings, Montana. We specialize in nationwide online payroll, tax preparation, business consulting and more. If you have an accounting need, we can handle that need!