You’re in good company if you saw this piece’s headline and are unsure about how an annuity works, let alone how it might impact your taxes. Despite being a potentially valuable retirement tool, data show annuities remain a mystery to many, including those approaching retirement age.
The American College of Financial Services recently found that annuities were the least understood retirement product among adults ages 50 to 75. That’s despite nearly half of working adults in that age group worrying about running out of money in retirement, according to the Life Insurance Marketing and Research Association (LIMRA).
Meanwhile, though annuities are not suitable for everyone, they can provide a steady stream of retirement income that some experts say shouldn’t be overlooked. But, as with other financial investment products, annuities present advantages and potential pitfalls when it comes to taxes.
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Let's break down a few pros and cons.
What is an annuity?
Before delving into tax, it helps to know some fundamentals.
An annuity is a financial agreement that can convert your savings into a steady income stream during retirement.
- An annuity involves a contract with an insurance company where you provide them with funds in either a lump sum or through regular premiums.
- In return, the company commits to sending you payments that can last for a specific period or your lifetime.
It's important to note that an annuity isn't life insurance or a savings certificate.
Annuities can be more immediate or deferred and come in different types with distinct features and risks. Various interest rates and sometimes complex administrative fees and other charges are also involved.
Annuity tax advantages
The taxability of annuity payouts generally depends on whether pre-tax or after-tax money was used to fund the annuity, but annuities offer some tax advantages.
Keep in mind, that these are general potential advantages of annuities. Whether an annuity is a good investment for you will often depend on your financial situation.
Tax-deferred growth. Your investment earnings grow tax-deferred. Contributions to nonqualified annuities aren’t deductible, but you don’t pay taxes on the earnings until you withdraw the money. As a result, the amount can compound over time.
Lower federal income tax bracket. You may be in a lower federal income tax bracket when you start taking annuity distributions so, you may pay less tax on distributions.
Payout flexibility. Annuities offer various payout options, allowing you to structure withdrawals to suit your financial situation. This can help you manage your taxable income, potentially reducing your tax burden.
Annuity tax downsides
These are potential downsides of annuities, generally speaking. You and your financial or tax advisor are in the best position to decide whether an annuity is a good investment for you.
A key tax challenge with annuities involves tax rates. When you withdraw money from an annuity, the earnings are taxed as ordinary income. So, you might pay more tax than with other investment types that benefit from lower capital gains tax rates.
Then there are early withdrawal penalties to consider. If you withdraw funds from your annuity or cancel it before age 59½, you will likely face a 10% early withdrawal penalty and ordinary income taxes. There are some exceptions to potentially avoid the tax penalty.
Complex tax rules. Tax rules can be challenging, especially when distinguishing between qualified and non-qualified annuities.
- Qualified annuities are funded with pre-tax money, giving you a tax break now but requiring you to pay taxes on withdrawals later.
- Non-qualified annuities use after-tax dollars, so you don’t get an immediate tax benefit, but you owe taxes on the earnings when you withdraw.
Qualified annuities — often part of retirement plans like 401(k)s and 403(b)s — have IRS-imposed contribution limits, while non-qualified annuities don’t. Also, with a nonqualified annuity, any 10% early withdrawal penalty would be on earnings only, not the principal.
Non-qualified annuities also don’t require you to take required minimum distributions (RMDs). However, the IRS requires owners of most qualified annuities to take distributions, generally starting at age 73.
QLAC?
If you are worried about required distributions, there is a type of annuity called a Qualified Longevity Annuity Contract (QLAC) that you purchase by transferring funds from your qualified retirement plan account.
A longevity contract basically allows you to set aside some of your retirement savings and deal with the IRS tax implications later.
- For 2024, you can use up to $200,000 (lifetime limit subject to adjustment for inflation) from your 401(k), traditional IRA, or other eligible retirement savings account to buy a longevity contract.
- If you’re married, both of you can use your respective accounts to separately purchase QLACs.
A longevity contract allows deferring some required distributions until you turn 85. But remember, you’re deferring taxes, not avoiding them. QLAC payments are taxed as ordinary income, so your federal tax bracket will be a factor.
Annuities: Bottom line
Annuities’ different rules, fees, and features can be challenging. However, you have to navigate these requirements effectively to avoid unexpected tax liabilities.
As always, it’s good to consult a trusted and qualified financial or tax planner to help you evaluate the tax implications and decide whether an annuity fits your retirement strategy.
Note: This item first appeared in Kiplinger Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that’s right on the money.
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