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Do Annuities Receive Favorable Tax Treatment?

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Annuities are an investment that many consider, especially during retirement. One of the reasons people choose it is because it is a low-risk vehicle. However, the common question asked is if it receives favorable tax treatment compared to others. Do you get fewer taxes or keep profits up to a particular limit without taxes?

A Brief Overview of Annuities

An annuity is a financial product you purchase that provides guaranteed income during retirement. You can withdraw the amount at a certain period or get monthly payments throughout your later years. Contributing to an annuity is like paying for any other retirement fund. You add funds to it and allow it to grow over time through investments. There is also an option to purchase them outright through a lump sum payment.

Annuities increase in value thanks to the money invested into indexes or stocks. Some products also give you interest that accrues over time. There is no guarantee when it comes to the gains, but the insurance company guarantees you a value you’ll get once you reach a withdrawal age.

Annuities are a low-risk investment because you have a guarantee of payments. These contribute to your principal investment, at a minimum. There are also ways to customize it depending on your risk tolerance and other desired features (insurance, beneficiaries, etc.).

How Taxation Works on Annuities

Annuities accumulate tax-deferred, meaning that taxes won’t be applied to them until you begin withdrawing. One of the benefits of this is that you have a higher amount to invest in the stock market. The growth can be faster because you get to place money there, only getting taxed later.

There is also the idea that most people retire at a lower tax bracket than their current position. They can strategize their annuities to pay fewer taxes upon withdrawal.

Once you are contributing the money, it isn’t necessarily tax-free. You don’t pay tax when contributing to the fund. It will only get taxed once you receive the money. The rate of taxation depends on your tax bracket and current income.

These are the basics, though some complexities can arise depending on your situation. When you find yourself in a situation like this, it’s best to consult a professional.

The difference that annuities have over other products is that they are subject to ordinary income taxation. Apart from that, the type of annuity you have will also determine its taxes. Qualified annuities have different rules than unqualified ones. Most other investments have a capital gains tax that applies based on your profits and losses.

Qualified Annuity Taxation

Qualified annuities are similar to your 401(k) or IRA. You purchase the annuity and allocate pre-tax income to it. It then grows using your current income without worrying about taxes until withdrawal. Once you get distributions, you’ll then have capital gains-based taxation. There will also be an ordinary income tax on your principal. There will be no added penalties as long as you withdraw during retirement.

However, if you withdraw before you’re 59 ½ years old, you’ll incur a 10% penalty on the income alongside the taxation. Theoretically, you can hold an annuity and keep it generating wealth for as long as possible until you’re ready to receive payments. The tax will only apply when you decide to start withdrawing or receiving money from it.

Unqualified Annuity Taxation

The unqualified annuity is the opposite of the qualified one for tax payments. Here, you’ll pay tax on the money first before putting it into the annuity. When you begin withdrawing, you no longer have to worry about ordinary income tax during retirement. However, there are still capital gains tax and interest payments on any returns you get during the distribution phase.

Favorable Tax Treatment

Yes, annuities receive favorable tax treatment. Several advantages attract many to purchase one. They are:

Long-Term Care Insurance

Many annuities can function as long-term care insurance when you purchase them. That means you can withdraw the money tax-free as long as it is for long-term care. You won’t have to worry about deductions when purchasing for assisted living, nursing homes, and the like.

Less Taxable Income

Since you’re paying pre-tax dollars for qualified annuities, that means that any income left will be the only one taxable. You pay less taxes every pay cycle while your investment grows tax-free. The money in the investment will have a better chance of compounding.

You’re likely in a lower tax bracket because of your lower annual income when withdrawing. You’ll pay less than you did when you started contributing.

The Exclusion Ratio

Non-qualified annuities have something called a tax exclusion ratio. For example, if you deposit $50,000 into the annuity expecting to receive double, the IRS will not impose further taxes on the principal.

They will apply the exclusion ratio when you annuitize a non-qualified annuity. That means the IRS will compute the annuity based on its earnings, principal, and length. Afterward, they will add life expectancy. You’ll only get income tax on annuity payments that are longer than their calculations on expectancy.

What About an Inherited Annuity?

Inherited annuities have similar tax specifications. Beneficiaries will still pay taxes on the principal and earnings if they inherit a qualified annuity. Non-qualified ones only consider earning taxation. There are some exceptions.

For example, a spouse can retain the tax situation of the previous policyholder. Non-spouses also have the option to change the payments to a lump sum or installments, depending on their current tax situation.

A Consideration on Lump Sum Withdrawals

A financial emergency can happen, leading you to the last resort of withdrawing the money from your annuity earlier than expected. There are many reasons this occurs, medical needs, job loss, and calamities, to name a few. While we want to avoid this, you’ll want to consider what happens when you make a lump sum withdrawal on the annuity.

When you get a lump sum payment, it gets taxed at an income rate. That means it’s going to add to your current income. A person withdrawing $100,000 to pay for expenses when already earning $100,000 means they jump a few tax brackets. They might find it surprising how the tax rate increases suddenly for their withdrawal.

There’s also a 10% penalty to consider. The penalty will also apply before any other taxes from the withdrawal. That means withdrawing the $100,000 will result in a $10,000 fine. Then the remainder pays income tax before you get any benefit. You’ll have to consider these computations and whether or not withdrawing as a lump sum is the best move.

Is an Annuity Right for Me?

It is a question that many ask, but it’s hard to answer. An annuity is an option that can work for you depending on your financial circumstances. For example, it can be favorable for people who want a combination of tax advantages and a low-risk investment vehicle. However, since annuities get invested in indexes, they don’t have a higher ceiling for returns.

That may not matter if you’re looking for a guarantee. You can opt for a fixed annuity that guarantees payments regardless of economic performance. People may also want it because they can pass it on to a beneficiary.

You’ll also have to consider that it isn’t a liquid asset. Withdrawing earlier will incur penalties, and a lump sum payment may not be beneficial now.

To alleviate any concerns, it’s advised that you consult with a licensed financial professional before taking any action. 

They can help guide you in the decision-making process when determining if annuities seem like a good addition to your portfolio. It can supplement your retirement funds by providing guaranteed income when you retire. 

Final Thoughts

Both qualified and nonqualified annuities have distinct advantages. There is no single answer, as it depends on your current financial situation. Each is unique, so you’ll need to consult a professional to get the best option possible. The goal is to lower your tax burden and maximize growth. A professional will also consider your tax bracket and see if it’s possible to maximize the value of the annuity.

One of the best reasons to get an annuity is the guarantee. Regardless of how the market performs, you’ll receive payments of your principal at least. There is an option to list beneficiaries to inherit the annuity if you move on without using all of it.

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About the Author: Benjamin Hulburt

Benjamin Hulburt - Safe Wealth Plan