How to Pay Tax on an Annuity Withdrawal

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An annuity can be a useful savings tool for retirement. Investments in an annuity grow tax deferred. You do not owe taxes on investment gains until they are withdrawn in retirement. In exchange for this benefit, investors are supposed to keep their money in an annuity until retirement. An early lump-sum withdrawal is taxed severely. A single withdrawal from an annuity will be charged income tax on the full portion that is investment gain as well as a 10 percent early withdrawal penalty if the investor is younger than 59 1/2.

Calculate your total investment in the annuity. This is known as your basis for tax purposes. If you purchased a single-payment annuity, the basis is the original purchase price. If you made multiple payments into the annuity, your basis is the total of all payments.

Determine the current total value of your annuity. Your insurance company can provide you with this information.

Subtract the basis of your annuity from the total value of the annuity. This calculates your investment gains. For example, an investor has a $160,000 annuity with a $100,000 basis. His investment gains are $60,000 since $160,000 - $100,000 = $60,000.

Withdraw the money from the annuity. Investment gains are withdrawn first. You will withdraw your basis only after withdrawing all investment gains. Income tax is due on all investment gain withdrawals. A withdrawal of basis is received tax free.

Pay the early withdrawal tax penalty of 10 percent on your investment gains if you are under 59 1/2. There is no penalty for a withdrawal if your are over 59 1/2.

Report the investment gains as income in the year of withdrawal. If you are under 59 1/2, record on your income taxes that you made an early withdrawal from an annuity. The taxes and penalty are due in the tax year of the withdrawal. Continuing the example, if the investor withdraws $100,000, is 55 and in the 25 percent tax bracket, then he would owe $21,000 in taxes. This is because he is taxed 25 percent on the investment gains ($60,000 0.25 = $15,000) and another 10 percent for early withdrawal penalty ($60,000 0.1 = $6,000). So, $15,000 + $6,000 = $21,000.

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