There are numerous questions surrounding whether annuities are good financial products to purchase for retirement. These products can either guarantee an income for you, generate tax-deferred earnings, or ensure you don’t outlive your income. However, your annuity preferences will differ from someone else’s and learning how these financial products are taxed is an excellent way to ensure you make the correct decision.
In this article, we’re looking at the difference between qualified and nonqualified annuities and how they can be a great addition to your retirement plan. It also discusses some of the differences between the best fixed annuities and variable annuities. There are many benefits to annuities including the tax-deferred benefits some types of annuities offer. There are also rules and regulations you should be aware of if you plan on utilizing these financial products for your retirement plan.
What Is an Annuity?
There are two main categories of annuities: those that help you save for retirement over time and those that help you build income during retirement after you pay a lump sum. Accumulation annuities help you save for retirement and build tax-deferred earnings. Fixed rate annuities help you plan for retirement with their dependable interest rates and variable annuities give you more exposure to market-based investments, which can either increase or decrease your earnings based on what occurs in the market.
Generally, annuities that pay you a regular stream of periodic payments are classified as income annuities and purchased during retirement or in the years leading up to it. How much income you can expect during this time depends on a multitude of factors, such as how much money you pay for the annuity, when you purchased it, and how long you expect to live after you start taking payments. Payments can start soon after buying the annuity or you can defer your payouts to defer for tax benefits.
Taxation Inside and Outside of Retirement Accounts
You can either purchase annuities with prior post-tax funds. If you use funds from pre tax funds coming from accounts such as IRAs, 401 (k)s and 402 (b) plans, you’re purchasing a qualified annuity.
Conversely, if you purchase an annuity with funds that have already been taxed, such as income, or capital gains your annuity is considered a non qualified annuity. The interest you earn in both qualified and nonqualified annuities is not reportable on your tax return until you withdraw it. It is important to note that qualified annuities are subject to required minimum distribution rules and you must make withdrawals after reaching the age of 72.
If you purchase a nonqualified annuity, you are not subject to RMD rules and interest can continue to compound without tax until you withdraw some or all of your funds. This gives you an added advantage because you might not need your funds at age 72 and you will be able to wait with a nonqualified annuity.
Withdrawn income from all types of deferred annuities is taxed as ordinary income instead of long-term capital gain income. These tax implications apply to fixed-rate, fixed-indexed, variable, and income annuities.
Tax-Deferred Advantages and Drawbacks
The following provide some insight into the advantages of a tax-deferred annuity:
- Guaranteed income in regular payments
- Tax-deferred contribution growth
- Possible death benefits
- No medical screening or Health qualification required
- Guaranteed rates of return on fixed annuities
- No contribution limits
The following examples illustrate some of the drawbacks to tax-deferred annuities:
- Illiquidity
- High fees
- Fixed annuities with limited growth potential
Income Annuity Payments
Only the interest portion of the payment in a nonqualified In a nonqualified annuity is taxed. Your purchase premium, or the original investment amount, is not taxed when you make a withdrawal.
In deferred annuities, the IRS states you must withdraw all of the taxable interest before withdrawing tax-free principal. You can avoid this by converting your fixed-rate, fixed-indexed, or variable deferred annuities into an income annuity. You can also buy an income annuity in the first place.
Income annuities provide guaranteed streams of payments, starting either right away or in the future with a deferred income annuity. Each payment includes both taxable interest and tax-free return on your premium.
The 59 ½ Rule
The 59 ½ rule states that if you withdraw money from your annuity before age 59 ½, you have to pay a 10% tax penalty on your interest earnings as well as the ordinary tax on the amount. However, if you have a disablement at the time of withdrawal, the IRS might be able to waive this penalty.
Unique Tax Perks for Long-Term Care
Annuity interest used to pay long-term care insurance premiums can typically be withdrawn tax-free, depending on the situation.
Taxes At Death
Upon your death, your spouse can assume tax-free ownership of the annuity if you are married.
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
The IRS considers contributions made to a qualified annuity as deductible within IRS limits for retirement plans. This means the same deductibility limits apply to qualified annuities as for any other IRA, 401(k), or 403(b). Premium payments to nonqualified annuities are not deductible.
Qualified Immediate Annuities
Because the funds in a pretax qualified annuity haven’t been taxed, the total amount of payments received each year is considered taxable. These amounts count toward your required minimum distributions (RMDs).
Conclusion – Are Annuities Taxable?
Learning the ins and outs of how annuities are taxed will help prepare you for any other questions that arise while you try to choose the correct annuity for your situation. Having a professional annuity agent guide you through this process is an essential part of choosing an annuity and you should choose your annuity agent based on trust and expertise.
Annuities are not straightforward financial products and as with any large financial decision, especially one affecting your retirement, you should feel confident your decision is based on concrete knowledge and guidance rather than risk. Licensed annuity agents should be able to guide you through any questions you have with detailed information and inviting demeanors. You should never feel rushed while choosing an annuity.
