A qualified annuity and a non-qualified annuity are essentially structured in the same way. For instance, if you purchase a deferred annuity, the funds in the account are allowed to grow on a tax-deferred basis. This means that no taxes are due on the gains until the time of withdrawal.
The big difference between these two types of annuities is really in the way that they are taxed. Because of that, it is important to plan carefully so that you are able to maximize the amount of retirement income that you net after tax and can use to purchase the goods and services that you need in retirement.
How Much Tax Will You Pay on Income from an Annuity?
In order to determine how much of your annuity income will be taxed, it can help to take a step back and look closely at qualified and non-qualified annuities.
A qualified annuity is purchased with pre-tax dollars. This refers to money that has not yet been taxed. For instance, if you own a traditional IRA account and/or you are a participant in a traditional employer-sponsored retirement plan (like a 401k), the amount of your contribution is eliminated from your taxable income in the year you make the deposit.
Because of that, your taxable income for that year will be reduced – ultimately resulting in less income tax due (or a larger refund). But at some point, Uncle Sam will still want his money. So, because the money inside of the account grows tax-deferred, none of the withdrawals from a qualified annuity will have been subject to taxation.
But they will be when you make a withdrawal. At that point, 100% of the withdrawal will be taxed at your then-current ordinary income tax rate. What will that rate be?
Nobody knows. But looking over the past century or so, the top Federal income tax rate has been as low as just 7%, and as high as 94%. With that in mind, it is essential to try and reduce taxation in retirement in other areas.
Top Federal Income Tax Rates 1913 – 2020
Source: Inside Gov (http://federal-tax-rates.insidegov.com/)
With a non-qualified annuity, the contributions have already been taxed. Similar to with a qualified annuity, though, the growth that takes place in the account is tax-deferred. Therefore, upon withdrawal, the portion of the income that is considered a return of your contribution is non-taxable, while the portion that is considered gain will be taxable.
The IRS determines how much of each non-qualified annuity payment is gain, and how much is a return of your contribution, through a formula that is known as the exclusion ratio. There are several factors considered when coming up with the exclusion ratio. These include the principal and earnings, the length of the payout period, and the annuitant’s (i.e., the income recipient’s) life expectancy if the annuity is making a lifetime income payout.
Other Factors to Consider with Annuity Distributions
There are some other important factors to consider, too, with regard to annuity withdrawals and taxation. One is the age of the annuitant when receiving these distributions. In this case, if the income recipient is under the age of 59 ½, he or she will incur a 10% “early withdrawal” penalty from the IRS. This is in addition to any taxes that are due.
In addition, the IRS also requires qualified annuity owners to start taking distributions at age 72. This is referred to as the required minimum distribution (RMD) rule. In this case, at least a set minimum amount must be withdrawn each year. Otherwise, the annuity owner will face a penalty.
When is the Right Time to Start Taking Annuity Withdrawals?
There are many items to consider before you start to take annuity withdrawals. These factors typically include when you leave your employer (either voluntarily or as part of a layoff), as well as your age, when you plan to file for Social Security benefits, and any other income sources that you may have.
Because there are many rules associated with annuities, it can help to discuss your objectives with an annuity specialist. That’s where the Annuity Gator comes in. At Annuity Gator, our goal is to educate consumers on how annuities work, and how they can be used as an integral part of your overall retirement portfolio.
So, if you’d like to speak with an annuity specialist, feel free to reach out to us directly by phone at (888) 440-2468, or via email by going to our secure online contact form. We look forward to assisting you.