Deferred annuities offer powerful tax advantages. While annuity tax rules aren’t too complex, understanding them and properly naming beneficiaries assures you’ll get the maximum tax advantage.
Annuity interest is not taxed until it’s withdrawn. With a deferred annuity, the owner decides when to withdraw interest and pay taxes on it.
The flexibility to wait until you need the income has many advantages for the annuity owner, as well as the spouse and beneficiaries. Deferred annuities include fixed-rate, fixed-indexed and variable annuities.
Other interest-paying investments — such as money market accounts, savings accounts, certificates of deposit and bonds (except tax-free munis) — create taxable income unless they’re held in a retirement account. You must claim the interest earnings as income on your 1040 form and pay tax even if you don’t withdraw or use the income.
The Stealth Power of Tax Deferral
Compounding occurs when interest is paid on previously earned interest. So, let’s suppose you have a CD that’s paying 3.0%. All future interest will be compounded on the total of principal and accumulated interest.
But, unless your CD is in an IRA or another tax-qualified account, you’re not really getting 3.0%. For example, if you’re paying 25% in combined federal and state income taxes, you’d be earning only 2.25% net.
With a deferred annuity, if you’re earning 3.0%, you’ll keep it all for compounding. By allowing the annuity interest to remain untaxed and in your account, your money will grow and compound faster than money in a taxable account earning the same before-tax rate. At 3.0%, compounded annually, $10,000 will grow to $13,439 in 10 years. At 2.25%, you’d have $12,492. The higher your tax bracket and the longer you defer, the bigger the advantage.
Avoiding Taxable RMDs with the Right Kind of Annuity
Annuities can be purchased with pretax funds or after-tax funds. You can place an annuity within an IRA, Roth IRA, 401(k) or 403(b) plan. Such annuities are sometimes called qualified annuities.
Nonqualified annuities are purchased with funds that have already been taxed. In other words, you hold it in a taxable account instead of within a retirement account.
Annuities held in standard IRAs are subject to the required minimum distribution (RMD) rules, just like other IRA investments. This rule requires you to take withdrawals each year after you reach age 70½. Each withdrawal is fully taxable.
But nonqualified annuities are not subject to RMD rules, and that’s a big benefit. This lets interest continue to compound without tax until you withdraw it. For instance, if your annuity earns $1,000 of interest and you withdraw $200, you’ll only pay tax on $200. The balance, along with your principal, continues to compound tax deferred.
The interest credits and gains from all types of annuities are taxed as ordinary income, not long-term capital gain income. But your original investment (the principal) in a nonqualified annuity is tax-free when it is withdrawn, because you bought the annuity with money that had already been taxed.
Be Careful to Name Your Beneficiaries Correctly to Maximize Tax Advantages
If you’re married, your spouse does not have to pay taxes on an annuity when you die if you’ve named your spouse the primary beneficiary. Then, your spouse can assume ownership of your qualified or nonqualified annuity at your death and continue to earn tax-deferred interest. On the other hand, because children cannot assume ownership of a parent’s annuity, they do pay taxes on inherited annuities. So, it’s important to make the right designations when choosing your beneficiaries.
Here are two examples.
1. Jack Hill and Jill Hill are married, and Jack has an annuity in his name. They have three children. Jack would name Jill Hill – Spouse, as his primary beneficiary. And he would then name their three children as contingent beneficiaries.
If Jack dies first, Jill will become the new owner of the annuity, and she would pay no taxes on the annuity. Their children would then become the primary beneficiaries. If Jill dies first, Jack continues as the owner and the children become the primary beneficiaries.
2. Jack Hill and Jill Hill are married and jointly own an annuity. The primary beneficiary designation should read “surviving spouse” and the contingent beneficiaries should be their three children.
Joint annuity owners should not name their children as primary beneficiaries. In this example, if the Hills had put their children down as the primary beneficiaries, once either Jack or Jill passes away, annuity benefits would be payable to their children rather than the surviving spouse. And the accrued interest would be taxable.
Most often a single annuity owner will name their child or children or other relatives as primary beneficiaries. The next most common designation is to name a living trust as the beneficiary and allow the trust language to govern the payout.
Pick the Right Payout Option, Too
Most insurers let adult children beneficiaries choose their payment option. There are three choices:
- Taking a lump sum payout means that all accumulated interest is taxable in one year.
- Under the five-year option, the beneficiary can take their share of the annuity over a five-year period and spread taxes over five years. This often leads to a lower tax payment.
- The third option is receiving benefits over the beneficiary’s life expectancy.
To see the effect of this beneficiary decision-making process, let’s look at an example. Consider a 50-year-old unmarried male beneficiary with taxable income of $140,000, currently in a 24% federal tax bracket. As of 2019, his federal tax rate increases to 32% on income above $160,725. He inherits a nonqualified annuity with a value of $200,000 and a cost basis of $100,000.
Lump Sum Payout: Must report $100,000 in additional taxable income.
Tax on first $20,725 at 24% = $4,974
Tax on balance of $79,275 at 32% = $25,368
Total federal tax = $30,342
Five-Year Payout: The $100,000 gain is spread out evenly over five years, preventing him from exceeding the income limits of his current tax bracket. Total federal tax paid over five years = $24,000 at 24%.
Lifetime Payout: The $100,000 gain is spread out over his life expectancy of approximately 30 years, reducing significantly the taxable amount each year. Because most people experience reduced income and are in a lower tax bracket after retirement, this option would likely produce the lowest total tax paid of the three methods.
The Bottom Line
Tax laws gives annuities tax advantages because they’re designed to help people save more for retirement. These advantages also come with rules you need to follow to get the most benefit, so take care to follow them. One last tip: withdrawals before age 59½ may be subject to tax penalties. Annuities are meant for long-term savings.
Retirement-income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. Interest rates from dozens of insurers are constantly updated on its website. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information is available from the Medford, Oregon, based company at https://www.annuityadvantage.com or (800) 239-0356.
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