Episode Show Notes
So I had a conversation with my aunt over the holidays — she just moved to Knoxville, she’s sixty-eight, and the first thing she asked me was, okay, I’m in Tennessee now, does the state take a cut of my annuity income? And I realized I didn’t have a clean answer for her.
That is such a common question. And the short answer is no — Tennessee does not have a broad state income tax. But here’s where I always pump the brakes a little, because ‘no state income tax’ does not mean ‘no taxes on your annuity.’ There’s still a federal layer that matters a lot.
Right, and I think that’s exactly where people get confused. They hear Tennessee, no income tax, and they think they’re done. Tax planning complete.
Yeah, and that’s a mistake. So let’s actually back up and talk about what Tennessee does and doesn’t do, because the history here is relevant. There used to be something called the Hall Income Tax.
Oh, I’ve heard that name. What was that exactly?
So the Hall Tax was a state tax specifically on interest and dividend income. It wasn’t a full income tax — it didn’t touch wages or most retirement income — but if you had investment dividends or interest earnings, Tennessee was taking a slice. That was fully repealed as of January first, twenty twenty-one.
So it’s completely gone now.
Completely gone. Which means Tennessee residents today — whether you’re in Nashville, Memphis, Knoxville, wherever — you’re not paying state income tax on wages, on pension payments, on IRA withdrawals, on annuity distributions. None of it.
Okay so that’s genuinely good news for retirees. But you said there’s still a federal layer.
Always. And the way federal taxes hit your annuity depends almost entirely on how the annuity was funded — specifically, whether the money going in was pre-tax or after-tax. That distinction drives almost everything.
Walk me through that. Because I think a lot of people don’t realize their annuity could be taxed completely differently depending on where the money came from.
So there are two buckets. First bucket — qualified annuities. These are funded with pre-tax dollars. Think of an annuity held inside a traditional IRA, or one that came from a rollover from a four-oh-one-k. Because you never paid income tax on that money going in, the IRS taxes the full distribution when it comes out. Every dollar is ordinary income.
So you’re just deferring the tax bill, not avoiding it.
Exactly. You’re deferring it, which can still be strategically valuable — but yes, it’s coming. Now the second bucket is non-qualified annuities. These are funded with after-tax dollars, money you’ve already paid income tax on. And this is where it gets a little more nuanced.
How so?
Because with a non-qualified annuity, only the earnings portion of each payment is taxable. The part that represents your original premium — the money you already paid tax on — comes back to you income-tax-free. There’s a formula for figuring out what percentage of each payment is earnings versus return of principal. It’s called the exclusion ratio.
Okay, so picture my aunt. She puts a hundred thousand dollars of after-tax savings into a single premium immediate annuity. She starts getting monthly checks. Not all of that check is taxable.
Right. A portion of each payment is considered a return of her original premium, and that portion is excluded from federal income tax. The actual ratio depends on her age, the contract terms, the payout period — a tax professional can calculate that specifically for her situation. But the point is, it’s not all taxable.
That’s actually a meaningful difference in monthly cash flow if you’re living on that income.
Huge difference. And this is why I always say the type of annuity you own matters as much as the rate. Two people could have the same monthly payment and owe very different amounts in federal tax depending on how their contract is structured.
Okay, so what about a MYGA? I know we talk about those a lot — multi-year guaranteed annuities. How does tax treatment work there?
So a MYGA held outside of a retirement account — non-qualified — the interest accumulates on a tax-deferred basis. You don’t owe federal income tax on the growth while it’s sitting there compounding. You only owe tax when you actually take a distribution.
Which is one of the things that makes them appealing compared to, say, a regular bank CD, where you’re paying tax on the interest every year even if you don’t touch it.
That’s a really important distinction. With a CD, you’re getting a tax form every year on interest you may not have even withdrawn. With a non-qualified MYGA, that tax event gets pushed to when you actually take money out. Now, if it’s inside an IRA, same rules as any qualified account — distributions are ordinary income when they come out.
I want to go back to something you said earlier — that Tennessee residents often keep more of their annuity income than retirees in other states. Is that actually a significant difference, or is it more marginal?
It depends on the comparison. Some neighboring states do have income taxes that apply to retirement distributions, pension income, annuity payouts. So if you’re comparing Tennessee to one of those states, yes — the difference can be real money over a twenty or thirty year retirement.
Especially if you’re drawing down a sizable annuity.
Right. But I want to be careful not to oversell this. Taxes are one factor. Cost of living, healthcare, proximity to family — those all matter too. I’ve talked to people who moved to Tennessee partly for the tax climate and then were surprised by the sales tax.
Oh, that’s a good point. Tennessee has one of the highest combined state and local sales tax rates in the country, right?
It does. And property taxes vary by county — Shelby County, Knox County, Davidson County all have different rates. So your overall tax picture in retirement isn’t just about income tax. It’s the full picture.
Which is why you can’t just look at one number and call it a day. My aunt, actually — when she was deciding between Knoxville and a couple of other cities, she was so focused on the income tax piece that she almost didn’t think about what her grocery bill was going to look like with the sales tax on top.
Yeah, and that’s a really common blind spot. The income tax headline is attractive, and it should be — it’s genuinely favorable. But retirement budgeting is more than income tax.
Let’s talk about Social Security for a second, because I know that’s a big income source for a lot of retirees. Does Tennessee touch that?
No. Tennessee does not tax Social Security benefits at the state level. Zero.
Okay but federal does, right? That’s the thing people forget.
Federal absolutely does, depending on your combined income. Up to eighty-five percent of your Social Security benefit can be subject to federal income tax if your income is above certain thresholds. So even in a state with no income tax, if you’ve got Social Security plus annuity distributions plus maybe a pension, the federal tax on Social Security could be meaningful.
And this is where withdrawal sequencing actually matters. Like, the order in which you pull from different accounts can affect how much of your Social Security gets taxed federally.
Exactly. And that’s a conversation for a qualified tax professional, not something to figure out on your own. But the point is — Tennessee not taxing Social Security at the state level is genuinely good, and it still doesn’t mean you’re off the hook at the federal level.
What about pensions? I know Tennessee has a state pension system — the TCRS, Tennessee Consolidated Retirement System. How does that get treated?
Same as everything else at the state level — Tennessee doesn’t tax it. Whether you were a public school teacher, a state employee, or you worked in the private sector and have a company pension, the state is not taking a cut of those distributions.
Federal taxes still apply though.
Federal taxes still apply. Most pension distributions are ordinary income at the federal level because the contributions were pre-tax. So again — state is favorable, federal is still there.
I want to go back to something you said about annuity structure, because I think there’s a scenario worth walking through. Let’s say someone is sixty-five, they’ve got a hundred thousand dollars sitting in a traditional IRA, and they’re thinking about putting it into a deferred annuity inside that IRA. Does the annuity add any tax benefit in that situation?
That’s a really sharp question, and the honest answer is — the tax deferral benefit of the annuity itself is already baked into the IRA. The IRA is already tax-deferred. So you’re not getting an extra layer of tax deferral by putting an annuity inside it.
So the annuity inside an IRA is more about the contract features — income guarantees, death benefits, that kind of thing — not about adding tax efficiency.
Right. The tax treatment of a qualified annuity inside an IRA is the same as any other IRA distribution — ordinary income when it comes out. The annuity’s value in that scenario is the insurance contract features, not additional tax benefits.
Whereas if someone has after-tax money — money sitting in a savings account or a brokerage account — and they put that into a non-qualified annuity, now the tax deferral on the growth is actually adding something they didn’t have before.
That’s the scenario where the tax deferral feature of the annuity itself is doing real work. Because that money would otherwise be generating taxable interest or dividends every year. Inside a non-qualified annuity, the growth is deferred until distribution.
Okay, I want to push on one thing. We’ve been talking about this like the tax picture in Tennessee is pretty clean — no state income tax, federal rules apply, know your contract type. But are there situations where it gets messier? Like, edge cases?
A few. One that comes up — if someone takes a lump sum distribution from an annuity rather than spreading it out over time, that can push them into a higher federal tax bracket in that year. So the timing of distributions matters.
Because you’re stacking income.
You’re stacking income in a single tax year. Another one — surrender charges. If you take money out of an annuity during the surrender period, you might owe surrender charges to the insurance company on top of any taxes. Those are separate things, but people sometimes conflate them.
Right, the surrender charge is a contract penalty, not a tax.
Correct. And then there’s the ten percent federal early withdrawal penalty if you’re under fifty-nine and a half — same as with IRAs. That applies to annuities too. So if someone is younger and thinking about tapping an annuity early, they need to factor that in.
That’s a big one that I don’t think gets enough airtime. People think of annuities as retirement income tools, which they are, but they don’t always think about what happens if they need the money before they’re sixty.
And that’s exactly why the liquidity provisions in the contract matter. Some annuities allow a certain percentage of the account value to be withdrawn each year without surrender charges — but the federal penalty for being under fifty-nine and a half is a separate issue. You’d still owe that.
So to bring this back to Tennessee specifically — the state is genuinely favorable. But the federal piece is where the real planning work happens.
That’s a fair summary. Tennessee essentially gets out of the way. It doesn’t add a state layer on top of your annuity income, your Social Security, your pension, your IRA withdrawals. But the federal rules are the same for a Tennessee retiree as they are for anyone else in the country. And those rules are complex enough that they warrant real planning.
I think the thing I’d want someone to take away from this is — don’t let ‘no state income tax’ be the end of the conversation. It’s a great starting point, but it’s not the whole story.
Completely agree. And I’d add — the structure of your annuity contract is going to matter more than most people realize. Whether it’s qualified or non-qualified, whether it’s a SPIA or a MYGA or a deferred annuity, whether it’s inside or outside a retirement account — all of that affects your actual after-tax income in retirement.
Which is why this is not a do-it-yourself exercise. Like, you can understand the concepts, and I think it’s really valuable to understand them — that’s what we’re trying to do here — but the actual decisions need to involve a licensed agent and probably a tax professional who knows Tennessee.
A hundred percent. Someone who can look at your specific income sources, your contract terms, your withdrawal timeline, and tell you what your actual tax picture looks like — not a general overview, but your situation.
And the good news is, if you’re in Tennessee, you’re starting from a pretty favorable place compared to a lot of states. The state just isn’t going to be an obstacle in the way it would be somewhere else.
That’s true. And for retirees who’ve relocated to Tennessee from states that do have income taxes — or who are considering that move — the difference in state-level tax treatment can be a meaningful part of the retirement income math. Just don’t forget to look at the full picture, including sales tax and property tax, before you decide where to plant the flag.
My aunt would say the mountains around Knoxville helped her decision more than the tax code. But hey, the tax code didn’t hurt.
The mountains are a solid tiebreaker. But knowing you’re not going to owe state income tax on your annuity distributions is a pretty good reason to feel good about the financial side of that decision too.