Annuities are tax-deferred, which means you don’t pay taxes on the money while it’s in the annuity. Like a 401(k) or IRA, you only pay taxes on the money when you withdraw it.
If you fund your annuity with pretax dollars, called a “qualified annuity,” then everything you withdraw will be taxed at your ordinary income rates. If, however, you used after-tax dollars to fund your annuity, called a “nonqualified annuity,” you won’t be taxed on the portion of your withdrawal that represents a return of your original principal. Only your earnings will be taxed in a nonqualified annuity.
Nonqualified annuities use something called the exclusion ratio to determine how much of your withdrawal is principal and how much is earnings. The exclusion ratio is designed to spread the return of your principal out over your actuarial lifetime.
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