Annuities and Taxes

How Do Annuities Save on Taxes?

When saving money for retirement, most Americans focus on 401(k) plans and individual retirement accounts (IRA). Over the years, another form of retirement savings has gained a significant amount of popularity, annuity. Annuities help retirees, by supplying them with regular, guaranteed annual payments that last for decades, or even for the rest of their lives!

In addition to the reliability of steady retirement income, annuities also provide retirees with some taxation benefits. In short, any money that you invest into an annuity benefits from tax-deferred growth. This means that (depending on the type of annuity you purchase) when you start receiving payments in your retirement years, you may owe no taxes on your original contribution amounts. However, there are some important variables that can affect your annuity’s taxation structure.

Is an annuity something you should consider for your retirement portfolio? How do taxes affect the long-term viability of annuities? These are many common questions about how annuities save retirees money on taxes, so let’s dive into the answers.

What Is an Annuity?

Before we get too deep into the details, let’s briefly discuss what an annuity is. Annuities are sold by insurance providers, which is the first significant difference between an annuity and a 401(k) or IRA. This is because annuities have more in common with a life insurance policy than a typical retirement investment plan.

As the name implies, an annuity provides an annual payment to the policyholder. Depending on the type of annuity you purchase, you could receive these guaranteed yearly payments for the rest of your life (with a life annuity) or for a predetermined period of time (typically 10–20 years).

There are also some other interesting variables that are worth touching on before we dive into taxation. The rate at which your annuity grows is determined by whether you purchase a fixed or variable annuity. A fixed annuity earns interest at the same preset rate each year, while a variable annuity is tied to stock market activity.

It’s also important to understand that some annuities can be passed on to a loved one, while others cannot. You can purchase a “joint” version of a life annuity that includes your spouse, which will pass on your benefits to them if you die. Similarly, a “life with period-certain annuity” also transfers your guaranteed payments to a beneficiary if you pass away.

How Does Taxation Affect Annuities?

No matter which specific type of annuity you purchase, it will be a tax-deferred investment. In most circumstances, deferring taxes in retirement funds allows them to grow more robustly as time goes by. This is because you don’t pay taxes until you start withdrawing payments. Even then, you will only pay taxes on the earnings with many types of annuities, while your original investment remains tax-free.

Beyond these basic characteristics, how an annuity is taxed depends on if you have a qualified or non-qualified annuity. In short, you buy a non-qualified annuity using money you’ve already paid taxes on. On the other hand, you can purchase a qualified annuity using untaxed funds. Typically, this means you paid for the qualified annuity using money from another tax-deferred retirement fund, like a 401(k) or Roth IRA.

One common misconception about annuities is that the distributions are taxed as capital gains. However, unlike funds gained through the sale of stocks, bonds, real estate, and other investments, the IRS taxes annuity payouts as standard income. In other words, you pay taxes on this money just like you would for a paycheck earned at a job, and capital gains taxes do not apply.

How Are Qualified and Non-Qualified Annuities Taxed?

The biggest difference between qualified and non-qualified annuity taxation is the fact that qualified annuity withdrawals are taxed as income. In other words, you will pay taxes on the entirety of your annual distribution payments because you didn’t pay taxes on that money in the first place.

Meanwhile, a non-qualified annuity only requires you to pay taxes on the earnings accrued throughout the annuity’s life cycle. The amount of taxes you end up paying on a non-qualified annuity depends on the “exclusion ratio” of your account (more on this shortly).

Does Taxation Vary Between Qualified Annuities Within Traditional and Roth IRAs?

You can purchase a qualified annuity using funds from either a traditional IRA or a Roth IRA. However, there are differences in the way your payouts will be taxed once you reach retirement age. Is your annuity in a traditional IRA or a 401(k) account? If so, you will pay taxes on your payouts according to standard income tax rates. It’s also worth pointing out that an annuity within a traditional IRA is subject to the IRS’s required minimum distribution (RMD) laws. RMD rules stipulate that you must begin taking withdrawals from your account by the time you turn 72, and these rules apply to annuities within these IRAs as well.

On the other hand, the rules differ for Roth IRAs. If you opened the Roth IRA at least five full years ago, and you are at least 59 ½ years old, your payouts will not be subject to any taxation. However, any earlier distributions would be subject to the early withdrawal guidelines outlined in your original annuity contract.

What Is the Exclusion Ratio?

A non-qualified annuity’s exclusion ratio (also known as the General Rule) is a crucial factor when determining annuity taxation. The exclusion ratio is the percentage of the annuity payout that is not taxed. Typically, this refers to the portion of each annual withdrawal that comes from your original contribution. Remember, because you made this investment with money that the government already taxed, you will not need to pay taxes on it again.

However, the interest you earn through your annuity will be taxed by the IRS. In addition, if you have any sub-accounts within your annuity (which is typically applicable to variable annuities), you will also need to pay taxes on any earnings from those accounts. In general, the exclusion ratio is the amount of your up-front premium payment divided by your regular annuity withdrawal amount times, and the number of years in your contract.

For instance, let’s say you bought a non-qualified period-certain annuity with a 20-year payout structure for $200,000. If the insurance provider promised you a $13,000 annual payment (amounting to $260,000 total over the course of the annuity), your exclusion ratio would come out to roughly 77%. This means that 77% of the total payout from your annuity is excluded from taxation, while you will need to pay taxes on the remaining 23%.

Keep in mind that this is simply an example. It is not meant to be representative of a typical exclusion ratio, and you should speak with your insurance agent to determine the exact exclusion ratio of your non-qualified annuity.

An important detail of the exclusion ratio is that your insurance provider calculates the ratio based on the lifespan of your fixed-period annuity or on your estimated life expectancy. What happens if you outlive the insurer’s estimate? Assume that your insurer expects you to live for 20 years after purchasing your annuity. For each year you live beyond that 20-year estimate, your remaining payments will all be taxed in full.

After all, the exclusion ratio is based on spreading out your original investment over your remaining years. Once the entire principal has been returned to you by the insurance company, they consider all further payments to be derived from interest. Therefore, the IRS taxes those payments fully, as you have never paid taxes on these funds before.

Is There Tax Penalties for Early Annuity Withdrawals?

Let’s say that you purchased an annuity on your 40th birthday. At the time of purchase, you expected this nest egg to help carry you through your golden years. However, you experience financial hardships over the next couple of decades, and you end up having to withdraw funds from your annuity when you’re 55 years old.

Annuity payouts typically start after you turn 59 ½, so this would qualify as an early withdrawal. Unfortunately, this has a potentially severe tax penalty. In general, you should never withdraw any funds from your annuity before you reach retirement age. Still, emergencies happen (and so does insufficient planning), so sometimes it’s an unavoidable situation.

In these circumstances, you will pay a 10% penalty to the IRS. This is because the structure of an annuity indicates that you will withdraw your earnings before you withdraw your premium. Therefore, the IRS’s 10% penalty allows the government to recoup the money you would have eventually paid in taxes on your guaranteed annual payments.

Let’s illustrate this concept with another example. If your annuity earned $10,000 since the day you bought it and you decide to withdraw $10,000 from your account, the IRS will consider this entire withdrawal to be earnings from interest. Therefore, they will tax the entire $10,000 as regular income, so the full amount would be subject to your individual tax bracket rate. Then, they will also add the aforementioned 10% penalty on top.

If we assume that you’re in the 24% tax bracket, this means you will need to pay $2,400 in standard income taxes on this withdrawal, plus the $1,000 early withdrawal penalty. Therefore, your total tax penalty would be $3,400 — a whopping 34% of your total withdrawal. As you can see, the tax penalties for early annuity withdrawals can be severe and should be avoided at all costs.

How about if you cash out your entire annuity early in a lump sum? If you do this, you’ll need to pay standard income taxes on the portion that qualifies as earnings. Therefore, if you purchased a $100,000 non-qualified annuity and it has since gained $5,000 in interest, you will pay taxes on that $5,000. The remaining $100,000 will be returned to you tax-free, as you already paid taxes on those funds before you originally bought the annuity.

How Do Taxes Work for Inherited Annuities?

As we mentioned briefly earlier, there are certain forms of annuities that can be passed on to your spouse if you die before receiving all of your regular payments. A joint life annuity provides reliable retirement income for a married couple, and those payments continue even after one half of the couple dies. Similarly, you can assign a beneficiary for a life with period-certain annuity after you pass on.

For the most part, an inherited annuity also inherits the tax rules it was originally issued with, so there shouldn’t be any significant changes. If the person you inherited the annuity from bought it with previously taxed funds, you will still not be expected to pay any taxes on the principal withdrawals. That said, you should still speak with your insurance agent (and perhaps an accountant as well) to make sure you’re properly reporting your inherited annuity withdrawals on your taxes.

In Conclusion

Over the years, annuities have become a highly popular form of retirement investment. The predictable nature of the payouts makes an annuity a great choice for supplemental retirement saving, after you’ve exhausted your annual contribution limits for your 401(k) and/or IRA.

However, as you now know, there are many nuances in the way the Internal Revenue Service taxes annuities. Regardless of which type of annuity you have, there are usually stiff penalties for early withdrawals. Keep this in mind when purchasing your annuity. If you will need to dip into the account before you reach retirement age, the penalties almost always wipe out the benefits you would receive from the account. Therefore, don’t invest a penny into an annuity unless you can afford to wait to withdraw it until your distribution period begins.

If you have further questions about the tax benefits of annuities, you should discuss them with an independent insurance agent or accountant.

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