Annuities are designed to build wealth and income for your retirement through tax deferral. Interest earned in a deferred annuity (the most popular type) is not taxed until withdrawn. Deferring taxes accelerates savings growth because interest compounds faster without withdrawals needed to pay taxes.
Compounding occurs when interest is paid on previously earned interest. Most investments that earn interest, such as money market accounts, savings accounts, certificates of deposit (CDs) and most bonds, create taxable income. Since you’re paying federal (and often state) income tax on it each year, you’ll have less after-tax interest to compound, and your savings won’t grow as fast.
With a tax-deferred investment, all of your interest is compounded until withdrawn.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
How are annuities taxed?
Annuities have some unique tax advantages. In some cases, they can even be used to pay for long-term care without the usual taxes on distributions! But there are some potential tax pitfalls.
Annuities can be purchased with pretax funds or after-tax funds. Pretax accounts, such as IRAs and 401(k) and 403(b) plans, are known as qualified retirement plans. If you use an annuity to fund one of these types of accounts, it’s thus called a “qualified” annuity.
In contrast, “nonqualified” annuities are purchased with ordinary after-tax money. By shifting some of your money into a nonqualified deferred annuity, you can cut your taxes.
Interest earned in both qualified and nonqualified annuities is not reportable on your tax return until you withdraw it. However, qualified annuities held in retirement accounts are subject to required minimum distribution (RMD) rules. You must take withdrawals each year after you reach age 72, or 73 if you reached age 72 in 2023 or later.
Nonqualified annuities are not subject to RMD rules, so interest can continue to compound without tax until you withdraw some or all of it. This gives you great flexibility. Let’s say you do not need more income when you’re 72 or 73. With a nonqualified annuity, you can wait until you do need the income and benefit from more years of tax-deferred growth.
Income withdrawn from all types of deferred annuities is taxed as “ordinary income,” not long-term capital gain income. This tax treatment applies to fixed-rate, fixed-indexed, variable and income annuities.
Here are some key tax wrinkles regarding annuities:
Income annuity payments are only partially taxable
Your original investment — the purchase premium(s) you paid — in a nonqualified annuity is not taxed when withdrawn. Only the interest portion of the payment is taxable.
With a deferred annuity, IRS rules state that you must withdraw all of the taxable interest first before withdrawing any tax-free principal. You can avoid this significant drawback by converting an existing fixed-rate, fixed-indexed or variable deferred annuity into an income annuity. Or you can buy an income annuity in the first place.
An income annuity provides a stream of guaranteed payments, starting either right away with an immediate annuity or in the future with a deferred income annuity. As mentioned above, each payment includes both taxable interest and tax-free return of your premium.
The exclusion ratio depends on how long you’ve held the annuity, how much interest you’ve earned and how long the payments will last, but, for example, 75% of each payment might be tax-free return of principal and 25% taxable.
The age 59½ rule
If you withdraw money from your annuity before age 59½, you’ll typically owe Uncle Sam a 10% penalty on the interest earnings you’ve withdrawn as well as ordinary income tax on the amount. If you are permanently disabled at the time of the withdrawal, the IRS will waive this penalty.
A unique tax perk for long-term care
Annuity interest that is used to pay long-term care insurance premiums or qualified long-term care expenses can usually be withdrawn tax-free. This can be a big advantage.
Taxes at death
If you’re married, your spouse can assume the ownership of your qualified or nonqualified annuity at your death without any taxes.
Children who are beneficiaries are required to claim only the untaxed portion of the annuity on their tax return. Under certain circumstances, the annuity can be distributed and taxed over a number of years. If you name a charity as your beneficiary, you can partially or fully offset income tax liability.
Rollovers
You can roll over your IRA, 401(k) or 403(b) or pension plan lump-sum payout into any type of qualified annuity without taxes.
Deductibility
Contributions made to a qualified annuity are deductible within IRS limits for retirement plans. In other words, the same deductibility limits apply to qualified annuities as they would for any other IRA, 401(k) or 403(b) or other qualified plan. (See the IRS website for deductibility limits for IRAs.) Premium payments to nonqualified annuities are not.
Exchanges
Nonqualified annuities may be exchanged tax-free for another nonqualified annuity — a so-called 1035 exchange. You can trade an annuity that may not have the features you like for another annuity that has better features or may pay a higher rate.
Qualified immediate annuities
Because the funds in a pretax qualified annuity have never been taxed, the total amount of the payments received each year is taxable. These amounts count toward your RMDs.
A QLAC lets you reduce and defer RMDs
A qualified longevity annuity contract, or QLAC, is a qualified annuity that meets IRS requirements. QLAC income is 100% taxable, but it’s money you’d eventually have to withdraw from your IRA anyway. Payments can start at any age as long as they begin by age 85.
Over your lifetime, you can reallocate up to $200,000 from your IRAs to a QLAC.
A free quote comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling 800-239-0356.
Related Content
-
Capital Gains Tax Repeal on the November Ballot: What Voters Need to KnowCapital Gains A controversial capital gains tax is up for a vote in the upcoming election.
-
IRS Sued for Millions Over Employee Retention Credit (ERC) DelaysTax Credits The pandemic-era tax refunds for businesses have been a contention point for the agency, now employers are fighting for their cash.
-
Want to Turn Your Tax Bill Into a Refund? What to Do NowA few easy steps can help you avoid writing a check to the IRS. And if your most recent refund was a whopper, you might want to consider a few adjustments.
-
FTC Cracks Down: Fake Reviews Officially a No-NoCompanies can no longer buy and post online reviews that aren't by actual customers — and there's a hefty fine involved. Here's what to watch for.
-
Election Could Reshape Opportunity Zones and 1031 ExchangesTrump and Harris have divergent approaches to qualified opportunity zones and 1031 exchanges. See how each could fare under their administrations.
-
Six Reasons to Have Life InsuranceThe peace of mind from knowing your family is financially protected if something happens to you is invaluable, but there are other compelling reasons, too.
-
Is Medicare a Good Reason to Wait Until 65 to Retire?The average retirement age is 62, but many people wait until Medicare starts at 65. Should health care be the key driver of your retirement date?
-
Late to Retirement Planning? Four Ways to Help Catch UpIf you're afraid you're behind in saving for retirement, it's important to act. You can do something. Here are four ways to help get back on track.
-
Five Windows of Opportunity for Roth ConversionsWhen you convert a traditional IRA to a Roth IRA matters if you want to limit how much you pay in taxes.
-
Four Social Security Myths DebunkedWith so many headlines surrounding Social Security these days, what is fact and what is fiction? For instance, will the program really run out of money?
