There are a few different methods for taking annuity payouts.  Generally speaking, the two most common methods to receive cash payouts are the annuitization method (I) and the systematic withdrawal schedule (II).  The other is lump-sum payment (III).  Following is a definition of these options, how they are calculated and how they are taxed.

I. Annuitization Method

The annuitization method gives you some guarantee of monthly income for a determined period.  However, keep in mind that:

• All of these options lock you into a specific payout program that cannot be changed, and

• Unless you’ve purchased inflation protection, the periodic (monthly) payments are fixed and therefore have reduced purchasing power each year due to inflation.

Despite the cost (i.e., reduced payouts) of inflation protection, it’s generally worth getting because the steady drip of even low inflation can eat into your buying power over time.  You can buy an annuity that will boost your monthly income each year based on a prescribed inflation rate (typically 3% or 4%), but a better option is to get one based on the actual change in the Consumer Price Index.

Here are the most commonly available annuitization options:

1. Life Option
   The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant.  This option provides an income stream for life, which is an effective hedge against outliving your retirement income.

2. Joint-Lives (or Joint & Survivor) Option
   This common option allows you to continue the retirement income to your spouse upon your death.  The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife.  The amount paid to the second annuitant may or may not differ from the amount paid to the first annuitant.

3. Period Certain
   With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years.  Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years.

4. Life with Guaranteed Term
   This option combines the income for life provision of the life option with a guaranteed return of a portion of your investment.  It pays you for as long as you live, but adds a guaranteed period (e.g., 10 years).  If you die before the guaranteed period is over, your annuity is obligated to continue to make payments to your estate or beneficiaries for the period specified.

II. Systematic Withdrawal Schedule

Under this method, you can select the amount of payment that you wish to receive each month and how many you want to receive.  Your payments may vary in amount for a specified length of time or for life.  However, the insurance company that sold you the annuity will not guarantee that you will not outlive your income payments.  How much you receive and how many months you receive payments depends on how much you have in the account.  With this option, you assume the life-expectancy risk.

Systematic withdrawal schedules are common with variable and indexed annuities that have not been annuitized.  With these annuities the amounts you receive may depend upon earnings from mutual funds and your guaranteed interest rate.

III. Lump-Sum Payment

Taking out the assets in your annuity in one lump sum is usually not recommended because, in the year you take the lump sum, ordinary income taxes will be due on the entire pre-tax contributions and the investment-gain portion of your annuity.  Clearly, this is a very inefficient payout option from a tax minimization perspective.

Electing Not to Take Payments

If you have no need for income from the funds that have accumulated in your annuity, you can leave the funds there and have the annuity transferred to your beneficiary at your death.  However, keep in mind that with qualified annuities you usually must begin taking mandatory minimum distributions at age 73, and there is the Step-Up tax basis consideration (see below).

There are several factors that insurance companies use to compute your monthly payment amount.  Two of the most common are gender and age – both of which affect your life expectancy.  Since women have longer life expectancies than men, women won't receive as high of a payment as their male counterparts.  And, of course, the older you are, the lower your life expectancy.  A 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man because the older man's life expectancy is shorter.

Another major factor that affects the size of your monthly payout is the payout option that you select, which affects how long the payments will last.  For example, if you select the joint-lives option, your monthly payout most likely will be lower as the payment continues to your spouse after your death.

Finally, the size of your monthly payout depends also on the insurance company that you use, and its expected investment returns on your money.  If the company can make a 5% instead of a 3% return with your money, your payment will be higher.  However, the increase in your payment when returns are higher depends on whether you select a fixed monthly payout or a variable monthly payout from your annuity.  If you select the fixed amount, your payout will not change, and the insurance company assumes all investment risk.  Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so you assume the market risk.

Deferred annuities are great for safely accumulating money to be used at some future date to enhance income.  All the money invested can grow tax deferred until it is removed.  And with qualified annuities, the initial investment may be deducted from gross income thereby also reducing current income tax.

However, when you begin to withdraw money from an annuity, you must then pay taxes on all or a part of your distribution.  Any money that has not been previously taxed, including your initial investment, dividends and interest, will be taxed as ordinary income.  Almost universally, that tax will be higher than the long-term capital gains tax.

The IRS treats qualified and non-qualified annuities significantly different and understanding the differences can help you plan for taxes, distributions, exchanges and rollovers.

Taxes on Qualified Annuities

When you reach a certain age, the IRS requires you to begin taking distributions from your qualified annuities.  See the IRS RMD Retirement Topic.

The IRS requires owners of a qualified annuity to begin taking mandatory distributions (RMDs) when they reach age 73. Your first RMD must be by April 1st of the year following the calendar year in which you reach age 73. According to the Secure 2.0 Act, this age requirement changes to 75 starting on January 1, 2033.

By the required beginning date, you must either:

Minimum distribution tables are published by the IRS (Publication #590-B) for determining the amount of income that you must take each year after age 73 based on the combined value of your tax qualified accounts.  After the starting year for periodic distributions, you must receive at least the minimum required distribution for each year by December 31 of that year.  If no distribution is made in your starting year, the minimum required distributions for 2 years must be made the following year (one by April 1 and one by December 31).  All distributions from a qualified annuity must be reported to the IRS as ordinary income each year.

You can change the beneficiaries on your annuity account at any time, in some cases even posthumously, and the required minimum distribution amount can be changed to reflect the life expectancy of your heir, again allowing more money to remain in the tax-deferred account.

Until it is annuitized, you can rollover a qualified annuity to another qualified account (e.g., an IRA or another annuity) without creating a taxable event.  This might be done to increase the return on your policy or to change investment strategies.  However, the same rules will apply when it comes to taxes.  So long as you are in a taxable bracket, income taxes will be due on any voluntary or mandatory distributions from the new account.

Taxes on Non-Qualified Annuities

A simple partial withdrawal is usually the most desirable method for obtaining income from an annuity, but even for a non-qualified annuity the entire withdrawal could be considered taxable income.  For annuities purchased before Aug 14, 1982, the FIFO (first-in, first-out) method is used for withdrawals.  For annuities purchased after Aug 13, 1982, the withdrawal rule is LIFO (last-in, first-out), meaning that earnings (the taxable part) will come out first.

Only if you set up a systematic annuity income payment, will you get some tax relief by spreading out the taxable gain over the anticipated number of years that annuity payments will be made.  This does not reduce the amount that will ultimately be taxable, but it does spread it out and make the burden more palatable.

Only the earned interest, and not the original investment, is considered taxable in a non-qualified annuity.  However, you have two options with the earned interest.   You can either withdraw it as needed or reinvest it, tax deferred, for a later date.  If you choose to withdraw the interest, you must wait until age 59 ½ even though this is not technically a retirement account.   Otherwise, the IRS (not the annuity company) will penalize you for an early distribution.   However, you will never be forced by the government to take your interest or principal out at any age.

Once your contract is annuitized, part of each payment (from a fixed annuity) is considered a partial return of the basis (your contribution), and the other part (investment growth) is taxable income using an exclusion ratio.  Once you select your payout method with your insurance company, you should ask for your exclusion ratio, which tells you how much is excluded from being taxed.  If your exclusion ratio is 80% on a $1,000 monthly payout, then $800 is excluded from income tax and $200 is subject to ordinary income tax.

When the annuitant/owner dies, what happens to the annuity depends on the terms of the contract and the designated beneficiary. The contract's death benefit is typically the annuity's cash surrender value or a guaranteed minimum. It is paid out in full or in installments to the beneficiary. The IRS considers all tax deferred parts, the original investment (if a qualified annuity) and investment growth, paid out in full or in installments to the beneficiary as taxable income.

The flexibility as to what happens to the annuity contract is determined by whether the beneficiary is the annuitant's spouse. Many contracts permit a spouse to determine what to do with the inherited annuity. A spouse can change the annuity contract into their name and assume all original terms and conditions, which is known as a spousal continuation. If a qualified annuity, the spouse would be required to take required minimum distributions based on their age according to IRS Uniform Lifetime tables.

A non-spouse cannot change the annuity contract but can only access the funds based on the original contract's terms and conditions. A non-spouse beneficiary can be a person or an organization. Choosing underage children as beneficiaries can cause issues regarding settlement payments.