Yes. If your annuity is not in a traditional IRA, 401(k) or other retirement account, the way you take the money can make a big difference in the way it is taxed. No matter where the annuity is, earnings are not taxable until the money is withdrawn.
If you withdraw money from the annuity on your own instead of as a lifetime income stream, early payouts are considered taxable earnings—taxed at your ordinary income tax rate, not the lower capital gains rate. Payouts after that are treated as a tax-free return of principal. If you withdraw the money in a lump sum, you’ll have to pay income taxes on the difference between your original contributions and the amount you receive when you cash out.
If you convert a deferred annuity into an income stream (called “annuitizing”), a portion of each payout is considered a tax-free return of principal and a portion is taxable earnings. The principal is returned in equal tax-free installments over the payout period. If you have a life annuity with payouts that stop when you die, the payout period is the IRS’s life-expectancy number for someone your age. Divide your contributions by that life-expectancy number to see how much of each payout is a tax-free return of principal. You’ll be taxed only on the portion of each payout above that amount. (Your annuity administrator can help with the calculations.)
If your annuity is in a traditional IRA, 401(k) or other retirement account and all of your contributions were pretax or tax-deductible, all of the payouts will be taxed as ordinary income, no matter how you take the money. If the annuity is in a Roth IRA, all of the withdrawals will be tax-free as long as you’ve had the Roth for five years and are older than 59½.
Taxes are just one issue to consider when deciding whether or not to convert your annuity into a income stream, however. Annuitizing provides payments that last for your lifetime or a certain number of years, but you lose the flexibility of being able to tap the principal if you need more money in some years.