One of the key advantages of annuities is that they’re allowed to grow while putting off taxes until later. But that doesn’t mean policy holders can ignore Uncle Sam forever. And the way these vehicles are eventually taxed is often complex and misunderstood.

Qualified Versus Nonqualified Annuities
In general, annuity owners don't pay any taxes until they take their money out (unless the owner is a corporation or trust; nonhuman owners must pay taxes on the annuity's growth every year). Yet the amount of tax due depends a number of factors.

One of those is how the annuity is owned. If you purchased it with pre-tax dollars—as part of an IRA, a 403(b) or a similar tax-advantaged retirement account, for example—it's considered a "qualified" account, and the payments are fully taxable as ordinary income. On the other hand, if you bought the annuity with after-tax dollars, and not as part of a retirement account, it's considered "nonqualified" and only the net gain—the earnings or growth—is taxable, not the money you initially invested (also known as the cost basis).

"Income from a nonqualified annuity will be partly taxable and partly non-taxable, based on the cost basis," says Michael J. Zmistowski, a personal financial planner in Tampa, Fla.

The ordinary income tax rate applies whether it's a variable or fixed annuity. But calculating how much of each nonqualified annuity payout counts as taxable net gain and how much as part of the tax-free cost basis can be tricky.

"Nonqualified annuities with income riders are taxed using the last-in-first-out (LIFO) method," explains Joanne Lam, senior vice president of wealth management at Freedom Capital Management in Holmdel, N.J. "All earnings from the income rider are distributed first and are subject to ordinary income tax. Once the earnings are fully withdrawn, the remainder of the distributions are from the initial principal and are not subject to tax."

That is, distributions that exceed the annuity's net earnings are considered a return of the cost basis, and are thus tax free.

The Exclusion Ratio
If, however, the distribution from a nonqualified annuity does not come from an income rider but instead from a partial annuitization of the contract, the taxable portion of the payout is subject to a slightly more complex formula. Such contracts "follow a different calculation to determine the taxable portion of the income stream," says Todd Giesing, assistant vice president and annuity research director at the Secure Retirement Institute in Windsor, Conn. "This is called the exclusion ratio, and it simply calculates out a portion of income payout that would be gains under the assumption of predetermined mortality."

To put it another way, the exclusion ratio is based on the contract's expected return, which in turn is based on an annuitant’s life expectancy and age when he or she purchased the contract. Annuitants can calculate the ratio as the cost basis divided by the number of expected years they have left when they buy the annuity (according to the insurance carrier's mortality tables). So someone who buys an annuity at age 85 may have payments that are largely tax-free, whereas "if you get a quote for someone who is younger—say, 50—more of the payment would be taxed," says David Blanchett, a managing director and head of retirement research at QMA, a quantitative equity and multi-asset solutions specialist.

Tim Rembowski, vice president of member success at DPL Financial Partners in Louisville, Ky., says, by way of example, "If you owned [an annuity with a $100,000 cost basis] and you were determined to have 20 years left on the actuarial table, then $5,000 of each payment would be tax free. Any amount above the $5,000 would be taxed as income."

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