As you plan for retirement, an annuity can provide you with a steady stream of ongoing income – but before you make a commitment to one of these products, you need to have a good understanding of taxes and annuities. That way, there won’t be any unpleasant surprises down the road.
Tax-Related Advantages of Owning an Annuity
There are many different types of annuities available in the marketplace today. These include fixed, variable, and indexed products, as well as both qualified and non-qualified. In all of these cases, the growth that takes place in an annuity is tax-deferred.
This means that no tax is due on the gain in the account until the time of withdrawal – and because of this, your money can earn a return on your contribution(s), as well as on the gain, and on the amount of money that would otherwise have been used for the payment of tax.
This includes interest, capital gains, and dividends – all growing without being reduced by income taxation each year. Due to this tax-deferral, funds that are inside of an annuity have the opportunity to grow and compound exponentially – and that can be good news if you’re hoping to build up your account value.
That being said, though, Uncle Sam will eventually want his due. So, upon withdrawal, you will owe tax on some, or possibly even all, of the funds received. But knowing this ahead of time can help you to better prepare for what’s ahead.
How Much of Your Annuity Income Will Be Taxed?
Depending on the type of annuity you have, either some or all of the income you receive from it will be subject to tax. For instance, if you have a qualified annuity, it is likely that most or all of your contributions went into the account pre-tax.
In addition, the growth in the annuity is tax-deferred. Therefore, Uncle Sam will want the taxes that he is due. So, if none of these funds have yet been taxed, they will be taxable at the time of withdrawal or income receipt.
Taxation of Annuity Income
|Qualified Annuity||Non-Qualified Annuity|
|Contributions||Pre-tax Funds||After-tax Funds|
|Income / Withdrawals||Taxable||Partially Taxable (based on the exclusion ratio)|
On the other hand, if you have a non-qualified annuity, your contributions have likely already been taxed. Growth in these annuities is also allowed to take place on a tax-deferred basis. So, when you receive income or take a withdrawal from a non-qualified annuity, you will owe tax on the portion of that payment that has not yet been subject to taxation.
The portion of each payment that is taxable is determined using a method that is known as the exclusion ratio. This calculation takes into account the principal that was used to purchase the annuity, as well as the amount of interest earned and the amount of time you have held the annuity. It will also consider the annuitant’s (i.e., the income recipient’s) life expectancy.
Have More Questions About Taxes and Annuities?
While annuities can provide you with a long list of benefits, they are also considered highly complex financial products. So, before you dive in and purchase an annuity – and in turn, make a long-term financial commitment – it is important that you first have a good understanding of how the annuity works, and what you can anticipate in terms of performance and taxation.
That’s where we can help.
At Annuity Gator, our mission is to assist consumers in finding the right annuity, based on their specific needs. We are a team of annuity experts who are constantly monitoring the annuity marketplace and posting annuity reviews online in our annuity review database.
We can show you the good, the bad, and yes, even the ugly as it pertains to annuities. That’s because we feel that knowing the whole story is the only way to make a truly informed financial decision.
Want to chat with an annuity specialist who can help you better understand annuities and how they work? If so, feel free to reach out to us through our secure online contact form. Or, if you’d rather call us directly by phone, you can find us by dialing (888) 440-2468. We look forward to hearing from you.