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Annuities and Taxes

June 08, 2022

Taxes can be a considerable burden, especially if they're unexpected. If you have an annuity, you'll want to understand the potential tax implications. Annuities are long-term contracts from an insurance company where you invest your money. In return, you receive income in the form of regular payments. There are various types of annuities, but they generally all follow the same rules – you're taxed at the time of withdrawal.

Annuity Taxation

Tax-deferred annuities are an excellent way for taxpayers to reduce their taxable income. Contributing pre-tax income to an annuity premium allows your investment to grow. This means you'll be able to invest more immediately. All dividends, interest, and capital gains can be fully reinvested to potentially make you more money while they remain in the annuity.

Types of Annuities

Different types of annuities have their own particular terms and conditions. Some types of annuities include:

  • Immediate annuities
  • Deferred annuities
  • Fixed annuities
  • Variable annuities
  • Indexed annuities

The annuity contract determines how and when you begin making withdrawals from your annuity.

Qualified Annuities

The amount of taxes you pay at the time of withdrawal will vary depending on whether you purchased an annuity with pre-tax dollars. If an annuity contract was purchased with untaxed funds (such as a 401(k) or IRA), it's classified as a qualified annuity. When you receive payments from a qualified annuity, the entire payment is fully taxable and must be reported as income on your taxes. You'll pay taxes on the principal investment and interest, dividends, and capital gains.

Non-Qualified Annuities

Annuities bought with money that has already been taxed are said to be non-qualified annuities. Since you already paid taxes on the money used to purchase the annuity, you won't have to pay taxes on the principal portion of the annuity again. You will, however, owe taxes on your earnings. You will pay some taxes on your annuity income when you start taking annuity withdrawals.

Additional Fees

You cannot withdraw from your annuity until you reach age 59 ½. If you decide to withdraw prior, you may owe a 10% penalty on the taxable portion of the annuity withdrawal.

After age 59 ½, you may take a lump sum or keep the annuity as an income stream. If you take the lump sum, you’ll pay taxes on the entire taxable portion of the funds.

Avoiding Taxes

Annuities are tax-deferred but not tax-free. Regardless of the type of annuity, you only pay taxes when you begin taking withdrawals.

You can transfer your annuity to someone else to avoid the tax burden. For instance, you may want to pass the money down to a family member if you feel that the taxes are unmanageable for you.

You can also cash out on your annuity and use the funds to purchase a new annuity. Although this can avoid taxes on the initial annuity, there are also penalties and fees to consider; therefore, this method is not the best for investment purposes.

Annuities are complicated products. As with many investments, it is best to seek guidance from a financial professional. If you are considering adding an annuity to your portfolio, contact us today so we can help you find the best annuity for your situation.