Annuities are basically insurance policies. Financial organizations that sell annuities typically collect the value of the annuity in a lump sum, invest the money and add the interest to the original amount. That added interest compounds and is not taxed until the annuitant begins taking money from the account.
Annuities have several tax-deferral benefits:
- Unlike a 401(k) or other retirement options, there are no maximum limits to the amount of money that can be invested in an annuity.
- Compounded interest in the annuity is not taxed until the owner makes withdrawals or annuitizes the account.
- The tax-deferred amounts in an annuity include dividends, interest, and capital gains. Interest, dividends, and capital gains are fully reinvested, allowing the annuity to grow without being chipped away by taxes.
- The original investment (i.e., the principal) is not taxed. When the owner begins making withdrawals, except in a qualified annuity, only the interest earned is subject to income tax.
A simplified explanation of the annuity tax rule
The IRS General Rule for Pensions and Annuities stipulates that a monthly annuity income payment from a non-qualified (i.e., funded with after-tax money) has two parts: 1) the tax-free part—reimbursement for the net cost of buying the annuity, and 2) the taxable balance—the earnings.
Say you decide to use your annuity payments as a monthly benefit in addition to your Social Security and other pensions. When you receive those monthly payments, the best approach is to take advantage of the untaxed principal added to a like amount of interest earned.
An exception for a qualified annuity and the exclusion ratio
If the annuity was funded through untaxed money from a 401(K) or another tax-deferred account, any payments withdrawn are fully taxable as income.
Another qualifier known as “the exclusion ratio” also comes into play. The exclusion ratio involves the owner’s life expectancy. Live ten years past your actuarial life expectancy and any annuity payments you receive after that time are fully taxable.
Penalties for early withdrawal
The means and timing of your annuity withdrawal can affect your tax bill. Withdrawal of the funds before the owner turns 59½ could result in a 10 percent tax penalty on the taxable portion of the withdrawal.
Annuity inheritance brings similar tax obligations
Anyone who inherits an active annuity account is subject to the same tax rules. The amount of the principal funded with taxable money is not taxed. What the annuity account earned in interest is subject to regular income taxes.
Annuities are another hedge against income taxes.
Annuities aren’t for everyone. They can carry hefty maintenance fees and disadvantages for investors who aren’t into them for the long haul. However, for those who have maxed out their 401(k) or IRAs and want to avoid the volatility of stocks, annuities provide an additional hedge against income taxes.
Contact us to see if annuities are a good fit on your retirement portfolio. Our tax planning services will also factor in how you can leverage all your investments for the maximum tax advantage.