Annuities are a sort of insurance-investment hybrid offered by life insurance companies.
While they come in a variety of shapes and sizes, the basic structure is that the individual purchasing the annuity (the “annuitant”) pays an up-front premium to the insurer in exchange for the insurer’s promise of guaranteed future payments on a defined schedule.
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Therefore, you'll pay tax on every dollar until you're only left with your initial investment.
After you've withdrawn all your earnings, you can then withdraw your initial investment free of tax.
Taking money early The other major tax consequence has to do with the retirement-related nature of annuities.
The IRS imposes the same penalties for early withdrawals from annuities that it does for IRAs and retirement accounts.
Annuitized payments are divided into part principal and part earnings, with taxes on the earnings but none on the principal.
If you don't annuitize, then IRS typically treats withdrawals from annuities as being from earnings first.
The basic rules for annuity taxation The first question in evaluating the tax consequences of cashing in an annuity is what you mean by cashing the annuity in.
If you mean annuitizing the contract and starting to get regular payments, that's different from taking money out before you annuitize.
For this reason, annuities are sometimes described as “reverse life insurance.” And, because an annuity’s value grows over time, it also acts as a savings or investment vehicle.