Annuities and Taxes: What you Need to Know
Effectively planning for taxes is a big part of every retirement plan. Today, we’ll take you through the different areas to watch out for, and take advantage of, when using annuities. Depending on the type of annuity, how it’s funded and what you’re trying to achieve for your clients, understanding how to plan tax-efficiently is a must.
Funding
How the annuity is funded is the biggest factor of how it will be taxed. There are two major types of funding:
- Qualified: Qualified annuities are funded with pre-tax dollars, so distributions from annuities are taxed as ordinary income. They are generally used as a strategy for a tax-advantaged retirement and funded from a 401(k), IRA or other qualified source.
- Nonqualified: Funded with after-tax dollars, only part of the distributions from nonqualified annuities are only taxed. The earnings portion is taxed as ordinary income, but there are no additional taxes on the principal. With nonqualified annuities, depending on the annuity type you select will determine if an exclusion ratio is applicable or if the earnings will be paid out first and be fully taxable.
In both cases, whether qualified or nonqualified, annuities offer tax-deferred growth, earning interest and potentially allowing for compound growth. Of course, once your client is ready to start using the money from the annuity, taxes must be paid on the growth.
Spreading out the payments allows the client to spread out the taxes, instead of getting hit with them all once.
Accumulation and Distribution
The first phase of any annuity is the accumulation phase, which begins after the annuity is funded, but before any money is taken out. Depending on the client’s age when the annuity is funded, and how fast they intend to use the funds, the accumulation phase can last for years. Immediate annuities are intended to pay out quickly, usually within one to 12 months. Deferred income annuity payments begin after a period of 13 or more months.
The distribution phase, and the payment of taxes, begins when the client starts taking withdrawals. Early withdrawals, taken before age 59 ½ may also incur a 10% early withdrawal penalty. And, with qualified annuities, the IRS has set a minimum amount that must be withdrawn starting between ages 73 for clients born in the 1950s. These are known as required minimum distributions, or RMDs. For clients not needing their RMDs, there are strategies to consider that allow clients to defer those distributions and create more a tax-efficient transfer to their heirs.
Riders and Features
Additional riders and features within annuities can also influence how the annuity is taxed. A few common riders to consider are:
- Death benefit riders provide a benefit to a beneficiary after the annuitant dies. How the annuity was originally set up, and how the payment is received, will affect how it is taxed. If the beneficiary takes a lump-sum payment from a qualified annuity, for example, they will be hit with taxes on the full amount all at once. If the payments are spread out over a number of years, the taxes will also be spread out.
- Living benefit riders ensure a minimum income stream regardless of market performance. The income from this rider will be taxed as any other withdrawal would.
- Inflation protection adjusts payments to account for inflation. These gains will be taxed when they are withdrawn.
Tax Planning Strategies
In addition to providing tax-deferred growth, annuities can also be used to transfer wealth to an heir, to plan for a long-term care need, or to postpone RMDs. Find out more about how each strategy works:
Maximizing a Grandparent’s Legacy: Download this one-pager to discover how a joint-and-survivor single premium immediate annuity with a cost of living adjustment rider can provide guaranteed income for two different generations.
Using Nonqualified Annuities for LTC Planning: Annuities not being used for income can be exchanged tax-free for annuities that offer LTC benefits. Think about clients with annuities, and read our one-pager to discover how it works.
The QLAC Strategy for Deferring RMDs: For clients not interested in taking distributions when required, a qualified longevity annuity contract can help defer withdrawals—and taxes—to age 85. Check out our case study for more about how it works.
Although every annuity will experience some level of taxation, strategies for tax-deferred growth and tax-efficient transfer can alleviate some of the burden and maximize the amount clients are able to keep in their pocket.
New to annuities? Discover our library of annuity tutorials at Ash Retirement Income University.
Jim Dobler joined Ash in Jan. 2022 to develop our new Retirement Advanced Planning department. As a self-proclaimed data nerd with over 20 years in the industry, he loves looking at existing policies and comparing the solutions available on the market. In previous roles, Jim has been a financial advisor, a wholesaler, the head of sales for CANNEX and the president of an insurance agency.
