Navigating Annuity Taxation: Key Insights for Retirement Planning

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Understanding Annuities and Their Tax Benefits

Tax benefits are among the many reasons you might consider investing in an annuity. Annuities are contracts that convert your cash contributions into guaranteed payments over time—sometimes even for life. Because they’re often used to save for retirement, annuities share some of the same IRS tax rules and restrictions that govern retirement accounts like 401(k)s and IRAs, but there are unique tax treatments as well.

What Is an Annuity?

An annuity is a contract between you and an insurance company that guarantees lump-sum or regular payments, often for life. Annuities come in many different types.

For the purposes of understanding basic tax rules, it may help to know the difference between qualified and nonqualified annuities:

• Qualified annuities are purchased with pretax dollars. They’re often held in retirement accounts such as 401(k)s or IRAs.
• Nonqualified annuities are purchased with after-tax dollars and are usually held outside of regular retirement accounts.

Annuities may also be immediate or deferred:

• Immediate (or income) annuities convert a lump sum into payments that begin right away.
• Deferred annuities have an accumulation phase, during which payments and interest add up, and a starting date after which regular payments are made.

Tax Advantages of Annuities

The IRS offers several tax benefits that can make annuities useful for retirement savers. Here are a handful to consider:

Annuities Grow Tax-Deferred

Any interest or capital gains you earn while your money is invested in an annuity aren’t taxable in the year you earn them. Instead, you’ll be taxed on distributions or earnings (depending on the type of annuity) when you receive payments. Because you don’t have to pay taxes on earnings as you go, your money stays invested and continues to grow.

You Can Save for Retirement Beyond Contribution Limits

If you’ve maxed out your annual IRA and 401(k) contribution limits, you still may be able to purchase an annuity outside your retirement accounts to save even more for retirement. However, any retirement accounts you use to hold annuities are still subject to contribution limits.

Annuities Can Be Rolled Into a Roth

Roth annuities are funded with after-tax dollars, just like Roth IRAs and designated Roth retirement accounts. If you hold annuities inside Roth accounts, qualified distributions are untaxed. If your annuities are already held in a traditional IRA or employer-sponsored retirement account, you may be able to convert to a Roth, though the amount you convert may be subject to tax.

Annuities Give You Tax-Timing Options

Whether you’re trying to minimize your taxable income now or avoid a retirement tax bomb later, annuities give you additional options:

• Use pretax dollars to purchase a qualified annuity if you need to reduce your taxable income now.
• Defer taxes on your earnings if you expect to be in a lower tax bracket in retirement.
• Add a nonqualified annuity or Roth annuity to reduce or eliminate taxes on your distributions when you retire.

Whatever your strategy, be aware that tax implications can be complicated with annuities. Before purchasing an annuity, consider talking with your tax advisor to make sure you understand the potential tax liability—and savings. A tax advisor can also help ensure your annuity payments are structured and taxed correctly as you go.

How Are Qualified Annuities Taxed?

Qualified annuities are funded with pretax dollars. They’re often held within 401(k) retirement or traditional IRA plans, and generally follow the tax rules that govern these accounts when they are. Contributions are typically tax-deductible and distributions are fully taxable as ordinary income.

You must begin taking required minimum distributions from a qualified annuity beginning at age 73, unless it’s held within an employer-based retirement plan and you’re still employed there.

How Are Nonqualified Annuities Taxed?

Nonqualified annuities are funded with after-tax income, so the money you use to fund your original investment has already been taxed. When you withdraw money from a nonqualified annuity, you’ll owe taxes only on the portion of your payment that represents earnings.

For example, if you invest $50,000 in a nonqualified annuity and expect a total return of $75,000 (principal plus earnings), you’ll ultimately pay taxes on the $25,000 in earnings but not the distribution of your original $50,000. Your earnings are taxed as ordinary income.

What Is the Exclusion Ratio?

The exclusion ratio is the portion of a nonqualified annuity payment that is not taxed. Here’s how it works. Using our earlier example, you can divide your $50,000 in principal by your expected return ($50,000 plus $25,000 in earnings = $75,000) to get an exclusion ratio of 0.667. You can estimate the untaxed amount of each payment (or your total payments for the tax year) by multiplying the payment amount by 0.667.

You can use the exclusion ratio to calculate the taxable portion of your annuity payment(s) for as long as you expect to receive payments: for the term of your annuity (say, 10 years) or for your life expectancy (as found in IRS actuarial tables). If you receive payments beyond the term you used to calculate your exclusion ratio, you’ll no longer be able to exclude part of your payment as principal; your principal balance will be completely withdrawn. From that point on, your full payments will be taxed as ordinary income.

Taxes on Annuity Withdrawals

If you withdraw funds from an annuity before you reach age 59½, you may have to pay a 10% early withdrawal penalty tax to the IRS. The 10% penalty typically applies to the (taxable) earnings portion of a nonqualified annuity distribution and the entire withdrawal from a qualified annuity.

There are a few IRS exceptions that may help you avoid the penalty tax. Talk to your tax advisor to see whether you might qualify. In addition to IRS penalties, fees from your annuity provider may make an early withdrawal more costly than it’s worth.

The Bottom Line

Annuities can be useful for retirement tax planning, but understanding their tax benefits and how to deploy them can be difficult. You may want to enlist the help of a retirement planner, financial advisor and/or a tax pro to puzzle out how annuities may fit into your larger retirement plan, as well as your current tax situation.

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