There are, however, other retirement plans with exploring. Case in point annuities, which are tax-friendly. Also, annuities offer a number of advantages that make them an attractive investment for retirement. Primarily, this is having a guaranteed steady income that you can’t outlive.
Taxation of Annuities: How Are Annuities Taxed?
One of the main advantages of annuities is that they offer tax-deferred growth. Two factors make tax deferral an advantageous strategy:- The first benefit is that you can defer income tax on annuity gains until you retire. Generally, retired people have lower incomes and lower tax brackets than they did when they worked. By deferring your taxes into retirement, you can reduce your tax burden.
- Second, when you defer taxes, you earn interest on money that would otherwise be taxed. That means you get to keep that money before you have to pay it over to the IRS.
Are Annuities Tax-Free?
Do annuities have a tax-free status? Not exactly.Again. Taxes are deferred on annuities. As a result, you don’t have to pay taxes on the growth of the funds. But, the taxes are paid later when the funds are received.
Your annuity income is taxed as regular income when you do pay taxes. Tax rates depend on the amount of income you earn and the tax bracket in which you fall.
How Is an Annuity Taxed?
Obviously, as a person who has worked their entire life, you’re well aware of the importance that income taxes cost in your budget. However, retirement budgets are more restricted, so this becomes even more important.The tax treatment of income is further complicated by the fact that it differs from that of many other types of investments and annuities. In fact, dividends from stocks and bonds are more tax-efficient than stock dividends.
But, didn’t say that annuities tax-deferred?
That’s right. Tax-deferred growth is the hallmark of annuities. As a result, you pay no tax on distributions from accumulation annuities or regular payments.
Annuities may grow more over time because they compound undisturbed, unlike non-qualified investment accounts or savings accounts.
If you withdraw annuity money, the growth will be taxed as ordinary income, even though it grows tax-deferred.
What about the money you invested in your annuity? This money is taxed differently depending on whether it’s qualified or unqualified.
Qualified Annuity Taxation
Generally, annuities in qualified or non-qualified accounts are taxed differently. A qualified annuity is one purchased with pre-tax dollars. As long as it’s funded with pre-tax dollars, an annuity purchased through a 401(k), 403(b), traditional IRA, SEP-IRA, or SIMPLE IRA will be considered a qualified annuity.When you withdraw or receive payments from this annuity type, they are fully taxable as ordinary income. You may be charged the 10 percent penalty in addition to your full contribution if you withdraw early from the annuity.
Confused? I’ll try to clear up what a qualified annuity is.
Qualified annuities don’t withhold taxes from deposits. The taxpayer’s income, as well as the amount of taxes due, will be minimized as a result. Moreover, if no withdrawals are made from the qualified account, no taxes will be due on the growth.
Investors who retire and take an annuity or withdraw from the account will owe taxes on both their contributions and investment gains.
Taxes on distributions from qualified annuities are based on ordinary income, while contributions are not taxable in nonqualified annuities. The investment gains, which are generally a smaller percentage of the account, may be subject to taxes.
Unqualified Annuity Taxation
Non-qualified annuities, on the other hand, are those purchased outside of employee benefits, such as 401(k)s. You won’t be taxed once the funds are disbursed since you’re transferring existing funds that have already been taxed. This allows you to grow your annuity tax-deferred.- Savings accounts
- Non-IRA accounts
- Certificates of deposit
- Mutual funds
- Inheritance accounts
With most annuities, you can also include a death benefit. If you die before disbursements are made, your beneficiaries can receive the remaining funds.
When you withdraw money or receive a payout from your annuity, you are taxed on the earnings. Dividends, interest, and capital gains all fall under this category. There may be limits on how much you can withdraw or pay from investments based on the exclusion ratio.
What Is the Exclusion Ratio?
When you purchase an annuity, you must make an initial lump-sum payment. Annuity payments are considered a return on your principal, so you won’t have to pay income taxes on a portion of each payment. Due to the fact that the principal was paid after tax, the IRS won’t be hitting you up for money again.The amount you receive from your insurance company is a fraction of what you receive each month, quarter, or year. During the course of the investment, your original principal earns interest, and this interest is taxable. It’s kind of like how additional income streams work with taxes.
In the same way, gains made in annuity investment subaccounts are taxable. Untaxed funds are deducted from distributions before taxes are calculated. If your contract specifies a monthly exclusion ratio, you should receive it from your annuity company.
How Are Annuities Given Favorable Tax Treatment
- Favorable Tax Treatment for Deferred Annuities
Interest earnings on these annuities accumulate tax-deferred, which offers them tax advantages. As long as the contract is in the accumulation phase, there are no taxes to be paid.
In order to discourage investors from using deferred annuities as short-term investment vehicles, the Internal Revenue Code includes penalties and taxes on early withdrawals and loans.
In addition to being taxed as ordinary income, withdrawals are classified as earned income.
- Favorable Tax Treatment for Annuitization
- Favorable Tax Treatment for Long-Term Care Expenses
Annuity Withdrawal Taxation
Taxes are also affected by when and how you withdraw your annuity funds.There may be a 10 percent penalty on the taxable portion of a withdrawal from an annuity if you withdraw it before you are 59 ½.
You will be taxed on your earnings if you take a lump sum withdrawal after that age instead of an income stream. On the entire taxable portion of the funds, you’ll have to pay income taxes that year.
In addition to how the money is withdrawn, its tax status, whether qualified or non-qualified, determines how much tax is due. The withdrawal amount will be taxed if the annuity is qualified. In the case of a non-qualified investment, you will only have to pay income taxes on the earnings.
Withdrawals from non-qualified annuities are taxed according to the last-in-first-out (LIFO) rule. As a result, payments made from an annuity are taxed first as its growth element.
Annuity Payout Taxation
The Internal Revenue Service’s General Rule for Pensions and Annuities specifies that each monthly annuity income payment from a non-qualified plan is divided into two parts. Generally, you consider the tax-free part of the annuity to be the return of your net purchase cost. Earnings or taxable balance make up the rest.Inherited Annuity Taxation
Do beneficiaries have to pay taxes on inherited annuities if you pass away and your annuity is inherited by them? Beneficiaries follow the same rules as policyholders.In the case of qualified annuities, they have to pay taxes on the entire distribution. However, the earnings, not the principal, are taxable in a non-qualified annuity.
- Spousal death benefits. If a spouse wishes to roll over their annuity, they can do so. The annuity continues as if the surviving spouse were the original policyholder when this happens. When the spouse withdraws funds, all tax rules apply, and they will owe taxes.
- Non-spouse beneficiaries. A beneficiary of a qualified annuity who is not a spouse is subject to taxes based on the payout structure they choose. At the time of receiving a lump sum payment, the beneficiary must pay taxes immediately. Beneficiaries can, however, choose a periodic or monthly payment schedule to prevent bumping into a much higher tax bracket. Taxes will be due as the payments are made. By spreading out distributions over several years, massive income gains are avoided.
Frequently Asked Questions
1. Do You Pay Tax on Annuities?
Income taxes are due the moment you withdraw money or begin receiving annuity payments. If you bought the annuity with pre-tax money, you’ll be required to pay income tax on the withdrawal. When you buy the annuity with post-tax funds, however, you will only pay taxes on the earnings.2. What Type of Annuity Will Cause Immediate Taxation of Interest Earned?
Annuity interest is only taxable when it’s withdrawn, so don’t forget that.3. How Much Tax Should You Withhold from Your Annuity?
Taxes are deferred until you begin receiving annuity payments. You will be taxed on your income based on whether you purchased the annuity with qualified funds (pre-tax) or non-qualified funds (post-tax).4. Do Beneficiaries Pay Tax on Inherited Annuities?
Annuity earnings inherited from a loved one are taxed. Depending on the payout structure and whether the beneficiary is a surviving spouse or not, the taxed amount varies.5. Can You Completely Avoid Paying Taxes on an Annuity?
It is impossible to completely avoid paying taxes on an annuity. It is still your responsibility to pay taxes on any earnings you make (interest, dividends, or capital gains), regardless of whether you take a non-qualified annuity.Additionally, despite the fact that annuities help you to grow your money faster through tax-deferral, all distributions, withdrawals, or income from annuities are subject to regular income taxes. Unlike other forms of investment, your earnings will not be taxed at the more favorable capital gains tax rate.
However, you can spread your tax burden over a number of years by investing in an annuity contract that is tax-efficient. You can maximize your annual income and minimize your taxable income without jumping into a higher tax bracket by combining this strategy with a non-qualified annuity.
