Annuities and Taxes: What You Need To Know

Annuities and Taxes: What You Need To Know

It’s the peak of tax season; do you have your taxes filed yet? You do have a little breathing room this year, as the deadline for filing has been extended to Tuesday, April 18th. Still, it is time to put your documents in order and learn what to do with your annuities. Let’s take a look at how things work in the tax world, how annuities are handled, and what the benefits are to holding annuities.

How Does Annuity Taxation Work?

Annuity taxation can be a little bit complex, but we’ll explain the basics here. However, it is best to consult a tax professional for complete advice on annuity taxation.

  • Qualified annuities are taxed just like any other qualified account (an IRA, profit sharing plan, 401(k) or other tax-deferred account set up for retirement purposes.)
  • Nonqualified annuities have different rules, and they are different from most investments.
  • Nonqualified variable annuities grow tax-deferred until the policy is annuitized or until withdrawals start.
  • Nonqualified annuities do not provide a step-up in cost basis upon death, and deferred earnings are taxable as income to any non-spousal beneficiary.
  • A spouse may continue the policy to preserve tax-deferred growth.
  • Annuities are included in the estate for estate taxation purposes.

What Are the Benefits of Annuities?

One of the benefits of annuities is that they allow you to put away a large amount of cash while deferring tax payment. There is no annual contribution limit for annuities, unlike IRA accounts and 401(k) programs. This lets you save more for retirement, which is particularly helpful if you are close to retirement age and need to catch up with retirement savings. Your invested money compounds without any tax hits, so you can keep more of your dollars working for you. This is a huge advantage over taxable investments.

Cashing out means that you can either take a lump-sum amount from your annuity or set up guaranteed payments for a certain length of time or the remainder of your life, which gives you a steady income stream. Annuities typically serve as complements to Social Security and pension plans.

Tax Benefits of Annuities

Tax-deferred annuity investments grow with no taxes due until you make withdrawals later in life. At that point, only the earnings you have accrued are taxable, not the principal amount that you invested. Even better, you will be taxed at whatever your current regular income tax rate is; generally, people’s tax rates decline as they reach retirement age.

What Is the Death Benefit?

The death benefit of your annuity is the amount due to your beneficiary upon your death, according to the terms of the contracted annuity with your insurance company. The death benefit depends upon what type of annuity you purchased and how your payouts are determined within that annuity contract.

Several different payout methods are available, and you should know that not all of them pay a death benefit. Some annuities are set up to pay out during your lifetime only, and the payments stop upon your death. True death benefits pay your beneficiary the principal amount and any accumulated interest. These amounts are taxed to your beneficiary as ordinary income.

One other thing to be aware of is that a beneficiary who is your spouse can roll that qualified annuity into another qualified account tax-free. Beneficiaries other than your spouse can also set up a tax-free account, but it would be a special account called an inherited IRA. In either case, the beneficiary would pay taxes only on any amounts they withdraw from the annuity.

What Happens When You Withdraw From Your Annuity?

While you can withdraw from your annuity, it may be costly to do so. Be sure you review the rules of your annuity and federal tax law before you do it so there are no big surprises.

Making a withdrawal before the age of 59 1/2 requires that you pay the IRS a 10-percent early withdrawal penalty plus regular income tax on the investment-earning portion of the withdrawal.

Additionally, making a withdrawal within the first five years or so of ownership will likely cause a surrender charge to be owed to the insurance company. This penalty can equal at least seven percent of your withdrawal amount in the first year, and then it declines by one percent per year until it reaches zero. Also, be fully aware that some annuities have high surrender charges – as much as 20 percent.

However, you might instead get a pleasant surprise, because some annuities permit withdrawals of 10 percent without any surrender charge.

Do Annuities Help With Estate Planning?

If you have some money that you intend to leave to your children or other heirs but want to ensure that the income increases over time, an immediate annuity with stated annual increases can be attractive. Additionally, some insurers offer immediate annuities that have cost of living increases linked to an index, and others are looking at offering these types of contracts in response to increasing demand. Additionally, annuities are often protected against creditors in most jurisdictions.

Annuities can be a great financial tool for retirement and estate planning when properly used. As we noted earlier, the rules are complex, so if you need further clarification or answers to detailed questions, the best course of action is to contact a trusted advisor today!

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