How Are Annuities Given Favorable Tax Treatment

Annuity. zimmytws/Shutterstock

How are you saving for retirement? Like most people, you’re probably contributing to a 401k or IRA. There’s nothing wrong with that. After all, there were about 600,000 401(k) plans in 2020, with 60 million active participants and millions of retired and former employees. And, in the same year, nearly 29 percent of US households owned traditional IRAs.

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.

With that in mind, let’s explain how annuities are tax-favored and why they might be a good investment choice.

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.

There are, however, a lot of complicated rules surrounding what, when, and how these funds are taxed.

In order to avoid tax problems, it is best to consult with a tax professional when buying an annuity and before withdrawing money from it.

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.

Annuities differ from investment products such as mutual funds, which are taxed as capital gains. In some cases, your federal income tax rate could be higher than your capital gains tax rate.

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.

I can’t stress this enough. You won’t be taxed on your investment gains if you don’t withdraw them from the annuity. However, Uncle Sam will charge you once you begin receiving payments or making withdrawals.

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.

Generally, qualified annuities offer higher tax benefits. Additionally, take-home pay is less affected during the working years.

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.

An example of a nonqualified sourcing fund is;

• Savings accounts
• Non-IRA accounts
• Certificates of deposit
• Mutual funds
• Inheritance accounts

In contrast to 401(k) plans, there are no contribution limits. Moreover, there is no minimum distribution age. Likewise, no consequences are associated with transferring funds between policies through a 1035 exchange.

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.

Taxable amounts are determined by the exclusion ratio when you withdraw an annuity. As non-qualified annuities are funded with after-tax dollars, the exclusion ratio is used to determine how much income has been earned on the annuity. Taxes are imposed on withdrawals, but earnings may grow tax-free until they are withdrawn.

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.

As an example, consider investing $100 and receiving $200 in 20-dollar installments after 20 years. That would be a completely unrealistic expectation. However, it will suffice to clarify your understanding of exclusion ratios. In this case, the exclusion ratio would equal 50 percent, which represents the ratio of principal to return. Since you are collecting back your initial investment, the first $10 of every check received is tax-free.

How Are Annuities Given Favorable Tax Treatment

• Favorable Tax Treatment for Deferred Annuities

By deferring taxes, annuities can allow retirees to contribute more than the standard annual contribution to a 401(k) or IRA and make retirement savings grow faster.

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.

On top of that, withdrawals from deferred annuities before age 59 ½, incur an early withdrawal penalty tax of 10 percent.

• Favorable Tax Treatment for Annuitization

Upon withdrawal of an annuitized non-qualified annuity, the IRS calculates the tax liability. We call this calculation the exclusion ratio. According to this ratio calculation, the annuity’s length, its principal, and its earnings are taken into account.

In the case of a non-qualified annuity that pays annuitized annuity payments for the owner’s lifetime, the exclusion ratio will take into account their life expectancy. All annuity payments beyond the calculated life expectancy will be taxed as income if the recipient lives longer than their calculated life expectancy.

• Favorable Tax Treatment for Long-Term Care Expenses

Moreover, some fixed annuities (long-term care annuities) can be used to pay for qualified long-term care expenses tax-free.

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.

You won’t be subject to taxes on subsequent withdrawals once the annuity value exceeds the amount withdrawn.

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.

Rather than taking withdrawals from your annuity, income payments are made according to the expected number of payments. And the principal amount, as well as its tax benefits. Besides the rest of the payment, the remaining amount is considered earnings that are taxed.

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.

Once again, withdrawals from annuities are taxed at the ordinary income tax rate, not at the capital gains tax rate. Until the beneficiary withdraws the funds, they do not owe taxes. Depending on who the beneficiary is, though, the annuity’s taxes will vary.

• 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.

You can gain tax-deferred growth on your annuity if you purchase it during the accumulation phase.

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.

However, first-in-first-out (LIFO) applies to interest earnings from an annuity distribution that’s not in a retirement account. If you withdraw from annuities in a non-Roth retirement account (self-directed withdrawals or annuity payments), you’ll owe income tax.

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).

At that time, your withholding strategy may vary based on your overall income and tax bracket.

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.

By John Rampton

The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.