Annuities offer impressive tax advantages, with a few avoidable tax implications, depending on the type of annuity how you choose to withdraw money.
Annuities grow with compound interest, with tax deferred—you don’t pay taxes on the money as it grows, only when you withdraw money or receive payments from the annuity.
Payouts from all annuities are taxed as ordinary income, but the type of annuity can affect the amount of taxes you pay and when you pay them—which can make a significant difference in your retirement strategy.
Qualified vs. Nonqualified Annuities
Qualified annuities are funded with pre-tax money, like through an IRA or 401(k). Payouts from qualified annuities are entirely taxed as ordinary income.
Nonqualified annuities are funded with after-tax money. The principal of nonqualified annuities comes back to you tax-free, so you only pay taxes on the earnings made through interest over time.
The interest earned in both qualified and nonqualified annuities is not reported on your tax return until you withdraw it. That said, qualified annuities are held to Required Minimum Distribution (RMD) rules, meaning you must make withdrawals each year once you reach a certain age.
Since nonqualified annuities are not held to these RMD rules, you have more flexibility to begin withdrawing funds later if you don’t need to. This means that if you wait to withdraw money from a nonqualified annuity, interest can continue to compound tax-free, potentially adding years of growth you can benefit from when you need it.
With nonqualified annuities, payments are partially taxable based on an exclusion ratio, which determines how much of each payment is considered taxable income or tax-free return of principal. Once you’ve received all your principal back from a nonqualified annuity, all subsequent payments become fully taxable.
The Age 59½ rule
If you withdraw funds from an annuity before reaching age 59½, you’ll typically owe a 10% tax penalty on the interest earnings you withdraw, in addition to the ordinary income tax on the amount withdrawn. This penalty is waived if you are permanently disabled at the time of the withdrawal.
Long-Term Care
Annuity interest that is used to pay for qualified long-term care expenses or long-term care insurance premiums can generally be withdrawn without owing any taxes, which can make a huge difference.
With certain types of fixed indexed annuities, a long term care rider can be added—in which case, if you become unable to perform the activities of daily living, your payments can increase significantly for a period of time (usually around five years).
Taxes at Death
Upon the death of a married annuity owner, their spouse can inherit both qualified and nonqualified annuities tax-free.
When children are named as beneficiaries, they’re only obligated to report the untaxed portion of the annuity as taxable income. In some cases, the annuity payout and associated taxes can be spread over several years.
Designating a charitable organization as your beneficiary offers the potential to reduce or eliminate income tax obligations on the annuity.
