If you’re thinking about ways to maximize your retirement income and ensure you don’t give away more than you legally need to come tax time, annuities are a viable option to consider.
But wait, annuities are not a simple black and white issue, especially when it comes to retirement and taxation. You want to be sure you own the annuity correctly, that it’s distributed properly, and that you understand the ins and outs well enough to manage it both before and during retirement.
Let’s start at the beginning.
An annuity is a type of financial product designed to ensure you don’t outlive your money. Sold by insurance companies, annuities are sold with a contract between you and the company, with both parties agreeing to basic terms.
The insurance company agrees to pay out regular monthly payments until the end of the contract, or until you pass. And you agree to make your payment toward that annuity, either in lump sum form or in monthly installments.
There are two basic types of annuities:
Income or Immediate
An income, or immediate, annuity requires you to pay one lump sum in order to immediately begin receiving monthly payouts. You will usually buy this once you have retired.
Essentially, you are hedging your bets with the insurance company, giving them a sum to hold for you so you don’t spend it unwisely. In exchange, the annuity will earn interest over time, and it will pay you out an agreed upon amount each month.
Retirement or Deferred
A retirement, or deferred, annuity is one that you typically buy in the years leading up to retirement. You know retirement is looming, you have maxed out your contributions to your 401k and IRA accounts, and you want to add a bit more to your retirement income. An annuity is often the next financial instrument in which to invest.
The annuity will continue to grow tax-deferred and earn interest until you retire.
Upon retirement, or on a date you specify after retirement age, you will begin to receive monthly payouts on your investment, and you will continue to receive them until you pass.
Annuities can be hugely beneficial for people planning for retirement or in retirement who have already maxed out their other retirement accounts.
Why are annuities considered more beneficial only after you have maxed out your retirement accounts, like 401k and IRA?
First, a 401k plan will take your money out before it is taxed. And with a traditional IRA, you can write off your contribution, so you get money back on your taxes each year. Not so with an annuity.
While it is true that, like a 401k or an IRA, your money will grow in an annuity in a tax-deferred manner, once you receive payouts, you will pay a higher tax rate on the annuity payout than on a 401k or an IRA.
Annuity payouts are considered “income” on your tax return.
401k and IRA payouts are considered “capital gains” on your tax return and are taxed at a much lower rate.
The exception to this rule is if the annuity is part of an IRA plan, in which case it would be taxed as a capital gain because it is paid out in the form of an IRA payout.
The above type of annuity is referred to as a “qualified annuity.” It qualifies for the lower capital gains tax.
Another exception exists for what are called “non-qualified annuities.”
Non-qualified annuities are purchased outside of an IRA plan, and all of the original contribution will be considered “basis,” and will not be taxed because it was part of a tax deferred program and you already paid taxes on that income. But any growth above and beyond the original contribution will be taxed at the income tax rate.
So, let’s say you contribute $100,000 and by the time you begin taking monthly payments, called annuitizations, your annuity has grown to $200,000 – you will be taxed at the income tax rate on the second $100,000.
Each time you receive a payout, the tax rate will be split 50/50.
50% will be taxed at the income tax rate. This 50% taxation is called “proration,” meaning you don’t have to pay out all of your taxes on each payment. The taxes you owe on the income you made are prorated over the length of your payouts.
Further, if you take any lump sums out, outside of your annuitizations, they will be taxed at the income tax rate until you withdraw down to the original basis amount. This concept is called “Last In First Out” (LIFO).
Essentially, you are taxed on the last money that went into the account, the income you earned on the annuity.
It can be tricky for annuity owners because you may be allowed withdrawals based on your annuity contract, but you will be paying higher taxes on that income as part of the LIFO taxation rule.
Withdrawal penalties are another factor to consider. If you buy a deferred annuity and begin contributing to it before you retire, but then you decide you need some of that money before you retire, you will likely pay a 10% early withdrawal penalty, just like you would with an IRA or 401k account.
The exclusion ratio is another consideration in annuity taxation.
While it is true that your basis annuity, the original amount you contributed, will not be taxed, that is only true for the duration of your life expectancy.
When you purchase an annuity, a calculation of monthly payments is made based on your life expectancy. But you are guaranteed payouts for as long as you live.
Thus, if you live beyond your life expectancy, you will still receive monthly payouts even if your original contribution and any interest earned are all paid out.
Keep in mind that you will have to pay income tax on the total payout you receive every month until you do pass.
Annuity Taxation: Food for Thought
A few other sneaky ways you may find yourself paying annuity taxes are in the case of gifted annuities, settlement annuities, company annuities, inherited annuities, and loan annuities.
If you are gifted an annuity, or you are thinking of gifting your annuity to a friend or family member, put some thought into it. Inherited annuities are taxable events for the donor. To add insult to injury, if the donor is under the age of 59 ½, they will likely pay the 10% early withdrawal penalty.
You think you lucked out in a settlement because you were paid out in the form of an annuity? Take caution. Settlement payouts should be tax free, but if this payout is structured incorrectly, what should be tax free could end up being a taxable event.
Any non-human purchasing an annuity loses the tax deferral benefit. So, a company purchasing an annuity for its employees is actually doing more harm than good, causing a taxable event where there need not be one.
An inheritor of an annuity will typically be subject to the same taxation as the original annuity owner, so while the deceased may have thought the annuity was a gift, it can actually create a taxation headache in the long run.
Some annuity owners think they can borrow against an annuity like they would a 401k or IRA. Not so fast. The loan is treated as a withdrawal and is subject to the LIFO rule, which requires it to be taxed as income.
Annuity Withdrawals and Taxation
The wisest payout decision when you withdraw from an annuity is simply to allow your normal annuitizations to take place, as you will be taxed over time at a much lower rate.
Avoid withdrawing large lump sums if at all possible as you will not only pay the higher income tax rate, but that lump sum may also move you into a higher overall tax bracket for the year, triggering a higher tax rate when you file at the end of the year.
The Short Version
An annuity is a financial instrument sold by an insurance company to retirees or those coming close to retirement. The annuity grows in a tax deferred account until you begin taking withdrawals, which, ideally, is after the age of 59 ½. Early withdrawals will cost a 10% penalty. Upon retiring and taking monthly payments called annuitizations, the owner of the annuity will pay income tax on any non-qualified annuity payment. The tax rate is based on the exclusion ratio. Qualified annuities are taxed at the lower capital gains tax rate.
In general, annuities are a great option for adding to retirement income, once other retirement account contributions have been maxed out for the year, but there are plenty of factors to be aware of before taking the leap.
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