Partial withdrawals are generally treated as taxable income to the extent that there are earnings in the contract. This means they're first treated as returns of interest earned and second as non-taxable returns of principal. (In the case of a "pre-TEFRA" annuity bought prior to August 14, 1982, partial withdrawals are considered a return of principal first and are not taxable until withdrawals equal the principal paid for the annuity.) A complete surrender is taxed under the "cost recovery" rule, which allows investors to receive tax-free returns of principal first, with additional amounts taxed as income.
Annuities enjoy favorable tax treatment since they are considered long-term investments, primarily for retirement purposes. To avoid their use as tax-favored, short-term investments, a 10 percent IRS penalty tax is imposed on the portion of any surrender or withdrawal that represents interest earnings, unless the payment is made to an owner who is over age 59 1/2, disabled, deceased, or the contract is annuitized over the life expectancy of the owner.
(Note: If only part of the accumulated contract value is withdrawn, the federal government considers that earnings are taken first, leaving the principal in the contract. That means income tax could be due on the entire withdrawal.)
Any non-deductible or after-tax amounts put into qualified annuities are not subject to income tax when withdrawn.
If money is withdrawn from a qualified annuity before age 59 1/2, the owner will have to pay a 10 percent penalty on the amount withdrawn in addition to paying the regular income tax. An exception to the 10 percent penalty is made when money is withdrawn from the annuity in a series of equal periodic payments over the owner's lifetime.
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