Annuities Highlights
By Joel Zimmerman

What are the Tax Benefits of Annuities?

There are many reasons why you should make annuities a key component of your retirement plan, one of the most important of which is their tax-deferral benefit. While the amount you invest in an annuity isn’t tax-deductible, you can defer paying taxes on the accumulated funds until you start making withdrawals.

This tax deferment gives a significant boost to your retirement savings, and can be of great value if:

  • You’re in a high tax bracket. If you have to pay a high tax rate for every dollar of your taxable income, then tax deferment is the right fit for you.
  • You’ve exhausted other tax-favorable investments plans. Unlike IRAs and 401(k) plans, there’s no limit to the amount contributable to annuities, so they are useful if you’ve already invested the maximum limit to, say, an IRA plan.

Understanding Annuity Taxation

Many investors mistakenly assume that annuities are tax-free and so lead to income growth. This isn’t quite true. No taxes are levied as long as the money remains within the annuity, instead of being paid out. Withdrawals within the first few years after the initial investment will be subject to an IRS penalty tax.

There are two phases in a deferred annuity. The first phase is the accumulation phase, wherein the annuity builds up and remains untaxed. In the second phase (the distribution phase), the annuity is disbursed. Annuity payments may be in the form of a lump sum or a series of income payments over a predetermined number of years.

Certain income taxes are imposed on annuity income regardless of the method of payment:

  • Taxes on Lump-Sum Payments
    If you’ve invested in a lump-sum annuity plan, you’ll be taxed on the difference between the amount you initially invested and the accumulated sum paid out to you.
  • Taxes on Annuitization
    Annuitization refers to the series of income payments made over a prefixed period. A part of each payment is regarded as a return on investment and the other part as your earning. Income tax is payable on the amount considered as earnings.
  • Taxes Levied on Variable Annuities
    With a variable annuity, income payouts are dependent on market performance. Here, the non-taxed amount of each payment is calculated as your investment divided by the period during which you expect to receive the payout.
  • Taxes on Withdrawals
    A withdrawal is any amount you draw in addition to your annuity payments. Depending on when you purchased the annuity, these withdrawals are taxable. For investments made after August 13, 1982, the first money withdrawn from the annuity is taxed as income. In the same way, money withdrawn before the annuitant reaches the age of 59½ is subject to an early penalty withdrawal of 10%.

Allowing the investment in an annuity to accumulate untaxed can seriously boost your retirement nest egg. If you’re not sure which annuity type is right for you or want to learn more about your options, get in touch with an independent financial advisor like LifeCentra today.

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