Annuities Offer Powerful Tax Advantages Plus Some Avoidable Pitfalls

Annuities are designed to build wealth and income for your retirement through tax deferral. Interest earned in a deferred annuity (the most popular type) is not taxed until withdrawn. Deferring taxes accelerates savings growth because interest compounds faster without withdrawals needed to pay taxes.

Compounding occurs when interest is paid on previously earned interest. Most investments that earn interest, such as money market accounts, savings accounts, certificates of deposit, and most bonds, create taxable income.

Since you’re paying federal (and often state) income tax on it each year, you’ll have less after-tax interest to compound, and your savings won’t grow as fast.

With a tax-deferred investment, all of your interest is compounded until withdrawn.

Annuities have some unique tax advantages. In some cases, they can even be used to pay for long-term care without the usual taxes on distributions! But there are some potential tax pitfalls.

Taxation outside and inside of retirement accounts

Annuities can be purchased with pretax funds or after-tax funds. Pretax accounts such as IRAs, 401(k) and 403(b) plans are qualified retirement plans. If you use an annuity to fund one, it’s thus called a “qualified” annuity.

In contrast, “nonqualified” annuities are purchased with ordinary after-tax money. By shifting some of your money into a nonqualified deferred annuity, you can cut your taxes.

Interest earned in both qualified and nonqualified annuities is not reportable on your tax return until you withdraw it.

However, qualified annuities held in retirement accounts are subject to the required minimum distribution (RMD) rules. You must take withdrawals each year after you reach age 72.

Nonqualified annuities are not subject to RMD rules, so interest can continue to compound without tax until you withdraw some or all of it. This gives you great flexibility.

Let’s say you do not need more income when you’re 72. With a nonqualified annuity, you can wait until you do need the income and benefit from more years of tax-deferred growth.

Income withdrawn from all types of deferred annuities is taxed as “ordinary income,” not long-term capital gain income. This tax treatment applies to fixed-rate, fixed-indexed, variable, and income annuities.

Here are some key tax wrinkles regarding annuities.

Income annuity payments are only partially taxable. Your original investment—the purchase premium(s) you paid—in a nonqualified annuity is not taxed when withdrawn. Only the interest portion of the payment is taxable.

With a deferred annuity, IRS rules state that you must withdraw all of the taxable interest first before withdrawing any tax-free principal.

You can avoid this significant drawback by converting an existing fixed-rate, fixed-indexed or variable deferred annuity into an income annuity. Or you can buy an income annuity in the first place.

An income annuity provides a stream of guaranteed payments, starting either right away with an immediate annuity or in the future with a deferred income annuity. As mentioned above, each payment includes both taxable interest and tax-free return of your premium.

The exclusion ratio depends on how long you’ve held the annuity, how much interest you’ve earned and how long the payments will last; but, for example, 75% of each payment might be tax-free return of principal and 25% taxable.

Age 59½ rule. If you withdraw money from your annuity before age 59½, you’ll typically owe Uncle Sam a 10% penalty on the interest earnings you’ve withdrawn as well as ordinary income tax on the amount. If you are permanently disabled at the time of the withdrawal, the IRS will waive this penalty.

A unique tax perk for long-term care. Annuity interest that is used to pay long-term care insurance premiums can usually be withdrawn tax-free. This can be a big advantage.

Taxes at death. If you’re married, your spouse can assume the ownership of your qualified or nonqualified annuity at your death without any taxes.

Children beneficiaries are required to claim only the untaxed portion of the annuity on their tax return. Under certain circumstances, the annuity can be distributed and taxed over a number of years. If you name a charity as your beneficiary, you can partially or fully offset income tax liability.

Rollovers. You can roll over your IRA, 401(k) or 403(b) or pension plan lump-sum payout into any type of qualified annuity without taxes.

Deductibility. Contributions made to a qualified annuity are deductible within IRS limits for retirement plans. Premium payments to nonqualified annuities are not.

Exchanges. Nonqualified annuities may be exchanged tax-free for another nonqualified annuity—a so-called 1035 exchange.

Qualified immediate annuities. Because the funds in a pretax qualified annuity have never been taxed, the total amount of the payments received each year is taxable. These amounts count toward your required minimum distributions (RMDs).

A QLAC lets you reduce and defer RMDs. A qualified longevity annuity contract, or QLAC, is a qualified annuity that meets IRS requirements. It lets you defer up to 25% of RMDs until age 85 and thus reduce your taxes until the payments begin. QLAC income is 100% taxable, but it’s money you’d eventually have to withdraw from your IRA anyway.

Over your lifetime, you can allocate 25% of the total of all your IRAs or $135,000, whichever is less, to a QLAC.

Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. He writes on retirement income and annuities regularly for several leading financial websites.

A free quote comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.