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How Are Annuities Given Favorable Tax Treatment?

SmartAsset: How Are Annuities Given Favorable Tax Treatment?

Annuities are tax-advantaged investment vehicles that guarantee retirement income. Here’s how they can benefit your tax situation and how to tell if one is right for you.

A financial advisor can help you decide if an annuity is a good fit for your financial plan.

What Are Annuities?

An annuity is a financial product that you can buy and it distributes monthly installments in retirement. Insurance companies sell annuities and you can purchase them by paying a lump sum or portions at a time. Annuities accumulate wealth in various ways, including through interest accrual and indexing.

The annuity company guarantees your distribution amount but not your gains. As a result, your annuity might run out of money before you pass away. However, annuities are low risk, meaning you can’t lose your principal investment and will receive consistent payments as long as your account isn’t empty.

How Are Annuities Taxed?

The government doesn’t tax annuity funds until you start taking distributions in retirement. Because retirees usually generate less income, they enjoy reduced tax rates, meaning annuities protect investment dollars before retirement. In other words, although the government taxes all income, an annuity can help you pay taxes at the optimal time.

In addition, lowering your taxes during working years means more money goes into your annuity and earns interest instead of Uncle Sam’s coffers. As a result, you benefit financially by taking the money you would have paid in taxes and building wealth instead.

That said, taxes are complex. And it’s wise to review your finances with a financial advisor or tax professional to ensure buying an annuity will provide the tax benefits outlined above.

Qualified Annuity vs. Unqualified Annuity Taxation

Annuity taxation depends on the type. Two types of annuities exist: qualified and unqualified. Here are the differences for tax purposes.

Qualified Annuity

Qualified annuities consist of pre-tax dollars, similar to a traditional individual retirement account (IRA) or 401(k). You purchase a qualified annuity by allocating income toward it before the government taxes the remainder of the income. This annuity type gives the double benefit of lowering the tax burden of your current income and allowing your annuity to grow without taxes.

The government imposes taxes on distributions and capital gains only when you take distributions. In theory, your annuity could generate wealth tax-free forever if you never took payment from it. However, another crucial feature to remember is that if you take distributions before age 59.5, you will pay a 10% penalty on the income in addition to your other taxes.

Unqualified Annuity

Unqualified annuities consist of dollars you have already paid taxes on. For example, you might use money from your bank account to purchase an annuity. In this scenario, the government won’t tax your distributions as income in retirement. However, if you take distributions, the government will tax the annuity’s returns, such as capital gains and interest payments.

How Are Annuities Given Favorable Tax Treatment?

Annuities attract investors by offering three tax advantages:

Decrease Taxable Income

As outlined above, qualified annuities use pre-tax dollars. As a result, you pay less taxes on your remaining income while your investment grows tax-free in the shelter your annuity provides. In addition, when you take annuity distributions in retirement, your annual income is likely less than your career income, meaning you pay less taxes when you finally touch your money.

Exclusion Ratio

Non-qualified annuities receive the exclusion ratio for taxes, meaning that the IRS reduces your tax liability based on your principal deposits. For example, if you deposit $50,000 into your annuity expecting to receive $100,000 throughout retirement, the exclusion ratio prevents your initial $50,000 from suffering further taxes. In addition, your annuity’s duration can affect your tax rate.

Shelter for Long-Term Care

As modern medicine continues to increase lifespans, expenses for long-term care, such as assisted living and nursing homes, also increase. Unfortunately, it’s challenging for retirees to afford long-term care, especially if their investment strategy doesn’t account for extended aging. You can purchase an annuity to pay for long-term care with tax-free withdrawals.

How Are Inherited Annuities Taxed?

SmartAsset: How Are Annuities Given Favorable Tax Treatment?

Generally, inherited annuities retain their tax specifications. Inheritors of qualified annuities pay taxes on the principal and earnings of distributions, and inheritors of non-qualified annuities pay taxes on the earnings, not the principal.

However, there are nuances depending on who inherits the annuity. For example, if a spouse inherits the annuity, they can retain the identical tax situation of the first policyholder. On the other hand, a non-spouse inheriting a qualified annuity can choose between a lump sum or installments according to their tax situation. For instance, a lump sum can introduce undesirable tax implications, while monthly distributions are more easily managed.

What Are the Consequences of Early Annuity Withdrawals

Like with other retirement investment vehicles, early withdrawals introduce financial penalties that are best avoided. However, a financial emergency might drive you to draw money from your annuity. You’ll incur the following consequences in doing so:

Lump Sum Payments

Lump sum payments can make you jump several tax brackets. For example, a married couple earning $80,000 annually might withdraw $100,000 to pay for medical expenses. The lump sum will take their tax rate from 12% to 22% for that year.

 Early Withdrawal Tax Penalty 

Typically, withdrawing cash before you’re fifty-nine-and-a-half will incur a 10% early withdrawal penalty in addition to income taxes. Using the above example, the early withdrawal penalty would reduce their distribution to $90,000 before income taxes eat up more. As a result, you’ll benefit by waiting until retirement to withdraw money from your annuity.

FAQs About Annuity Tax Treatment

Do Annuities Lower Your Taxes?

Annuities defer paying taxes on the money you put toward qualified annuities. A qualified annuity lowers the taxes on your current paychecks. It also allows your money to grow tax-free and then pay taxes in the income during retirement, when your tax bracket is probably lower. Therefore, a qualified annuity doesn’t eliminate taxes but can reduce your tax liability during your career and retirement.

How Are Annuity Gains Taxed?

The government only taxes annuities when you take distributions. The IRS taxes your entire distribution from qualified annuities. On the other hand, because unqualified annuities use post-tax dollars, the IRS taxes the gains but not the principal of your distributions.

Do Beneficiaries Pay Taxes for Annuities?

If you receive inherited annuity payments as a spouse, you’ll experience the same taxes as the original policyholder. Conversely, a non-spouse beneficiary will pay taxes according to whether they take a lump sum or monthly installments.

How Much Should I Invest in My Annuity?

Because your financial situation is unique, there is no single answer for how to contribute to your annuity. Generally, investing as much as possible to lower your tax burden and maximize growth is a good idea. However, contributing $100 vs. $150 monthly might not change your tax bracket, meaning it’s only wise to deposit the higher amount if you can afford it and have no other investment vehicles.

Will I Pay Capital Gains Tax on My Annuity?

No. One of the perks of an annuity is that your distributions will not incur capital gains tax rates.

Is an Annuity Right for You?

Your financial circumstances and preferences will help determine if an annuity is right for you. For example, suppose you have a low risk tolerance. In that case, an annuity may be suitable, as your annuity’s contract guarantees a specific income level, regardless of how the stock market or economy performs.

Additionally, if you’re concerned about dependents, an annuity allows you to list specific beneficiaries to inherit your annuity, providing stable income until the funds expire. Also, because an annuity is a low-risk, low-reward financial instrument, it functions best in tandem with more aggressive investment types. For instance, if you max out your 401(k) or IRA annual contributions and have additional money to put away for retirement, an annuity can augment your retirement plan.

However, annuities are less liquid than other assets, meaning it can be challenging to access the money before retirement. Doing so will incur a 10% tax penalty. Plus, annuities typically contain clauses that impose a penalty for accessing funds within seven years of opening one. Lastly, annuities can have exorbitant fee structures, so make sure to read the fine print. An annuity’s interest rate and prospective gains might not be as impressive if fees cancel them out.

Bottom Line

SmartAsset: How Are Annuities Given Favorable Tax Treatment?

Annuities are tax-advantaged investment vehicles that can use pre- or post-tax dollars and allow your money to grow tax-free. Qualified annuities use pre-tax dollars, postponing taxes until retirement. In addition, non-qualified annuities use post-tax dollars that are taxed for gains when they’re withdrawn.

However, annuity distributions suffer heavy tax penalties if touched before retirement. Plus, their low yields generally make them unfit as your sole income source during retirement. That said, they can supplement an investment strategy and guarantee income independent of your stock portfolio.

Tips for Investing in Annuities

  • Annuity fee structures and accessibility clauses can be challenging to understand. A financial advisor can clarify whether an annuity is a helpful building block for your retirement plan. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Tax advantages are only one aspect of annuities. Before purchasing one, it’s a good idea to consider the other financial implications. Use this list of pros and cons of getting an annuity to ensure it’s your best option.

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