There are two types of deferred annuities, and both types share some of the rules regarding taxation of withdrawals. However, there are certain tax rules that only apply to one type of deferred annuity or another, and this is the reason for confusion regarding how and when taxes are due on annuity distributions. The two types of annuities are qualified and non-qualified, and withdrawals from either of these annuity types will result in taxation, but in different amounts and under different circumstances.
Contributions to a qualified annuity result in a dollar-for-dollar tax deduction for the annuity owner in the year in which the contributions were made. This means that the income tax that would have otherwise been paid to the government during the income-earning year is deferred until the money is actually taken as income by the annuitant. Income tax will be due on the entire amount of the withdrawal, regardless of whether the actual dollars distributed are considered to be part of the owner's contribution, or part of the earnings in the account.
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Contributions to a non-qualified annuity do not result in a tax deduction during the year in which those deposits are made. However, any taxes that would normally be due on the earnings within the annuity are deferred until the money is withdrawn. This creates the potential for confusion at the time of the withdrawal because some of the money in the account has already been taxed while some of it has not. The government rule regarding taxation of annuity withdrawals is last in first out, or LIFO. This means that the money most recently deposited into the annuity account is technically the first money to be withdrawn. An annuity's earnings will therefore be the first withdrawals, and subsequently taxed. Only after the earnings have been entirely depleted by withdrawals will the owner's contributions be distributed, and no taxes will be due on those portions.
Regardless of the type of annuity, any money withdrawn prior to the year in which the annuitant reaches age 59.5 will incur an IRS penalty of 10 percent of the taxable amount withdrawn. This is separate from and in addition to any income taxes due on the withdrawal.