Gregory S. DuPont
The Tax Advantages of Purchasing Annuities
As you are planning for your retirement, you may be considering purchasing an annuity, which can provide you with a steady flow of income for a limited period of time, or for the rest of your life. While there are many factors to weigh when you are thinking about buying an annuity, the tax advantages associated with many of these products can make an annuity an attractive investment choice.
Generally, an annuity is a long-term financial product offered by insurance companies and other financial institutions that is designed to accept funds from an individual, allow the funds to grow on a tax-deferred basis, and then upon annuitization make a stream of payments to the individual for the length of time specified, or for the remainder of the investor’s life. The income received from an annuity can be distributed on a monthly, quarterly, or annual basis, or be paid out in a lump sum. Annuity contracts may be structured to provide fixed payments to the annuitant, or variable payments based on the performance of the underlying investments.
If you are not yet retired or do not need to start receiving payments right away, you have the option of purchasing a deferred annuity, which gives you the opportunity to build your retirement savings over a number of years. If, however, you are already retired you may choose to purchase an immediate annuity, which starts paying out immediately after the initial investment is made. If you use pretax money from an IRA or a 401(k) to purchase a qualified annuity, then all of the payouts will be fully taxed. If, however, you use after-tax dollars to buy a non-qualified annuity, a portion of the payouts will be a tax-free return of your principal.
Although the premiums you pay into a non-qualified annuity will not provide you with any current income tax savings, unlike most investments made outside of retirement accounts or products, the earnings within the annuity account will not be currently taxable. Thus, the dividends, interest, and capital gains credited to the annuity are allowed to grow untaxed during what is known as the accumulation phase. In addition, if you purchase a variable annuity instead of putting your money into taxable investments, you can transfer the funds inside the annuity from one investment option to another without incurring a tax liability.
Saving for retirement by investing in a non-qualified annuity also offers certain advantages relative to contributing to a traditional IRA or 401(k) plan, including that the income payments under a non-qualified annuity can be deferred past age 70½. Thus, the payments can be taken when the need arises, and are not subject to the required minimum distributions (RMDs) that apply to qualified retirement accounts. Non-qualified annuities can therefore be particularly attractive if you are concerned about outliving your retirement savings.
As the funds are distributed to you in retirement, non-qualified annuity payments consist of two components: interest and principal. The interest is taxed as ordinary income, but the principal is tax-free because it is a return of your initial investment with after-tax dollars. The amount of each payment that will not be taxed is computed via an “exclusion ratio,” in which your investment in the contract, or principal, is divided by the total amount you expect to receive during the payout period. The percentages of principal and earnings of each distribution payment will depend on the annuitization option you have chosen.
If the payment is made as a lump sum instead of through annuitization, income taxes will be due on the difference between the amount paid into the annuity and its value when it is paid back. Taking a lump-sum distribution of your annuity funds is generally not advisable, especially if a large distribution moves you up to a higher tax bracket.
Unless an exception applies, when withdrawals are made from a non-qualified annuity before age 59½ the earnings portion of the withdrawal is subject to a 10% IRS penalty tax. As the rule in such cases is that interest and earnings must be withdrawn before the principal, early withdrawals are taxed until all of the interest and earnings are withdrawn; the principal can then be withdrawn without tax. Annuity providers may also impose surrender charges on early withdrawals.
It is also important to note that annuity contracts differ considerably in terms of how the remainder of the funds are paid out in the event that the annuitant dies prior to or during the annuitization period, and that the way these payments are distributed will have tax consequences for the beneficiaries. For example, if the annuitant dies prior to receiving any payments, the money may go to the contract’s beneficiaries, who will be taxed on the earnings in the annuity at ordinary income tax rates upon receipt. If, however, the contract had been annuitized prior to the annuitant’s death, then the heirs may or may not be entitled to receive payments.
In addition, since 2013 distributions from non-qualified annuity contracts, to the extent they are not excludible from income, have generally been subject to the 3.8% Medicare tax on investment income for taxpayers with adjusted gross incomes over $250,000 in the case of married couples filing jointly, or $200,000 in the case of single filers.
You should also bear in mind that guarantees associated with annuities are subject to the claims-paying ability of the annuity issuer. And while variable annuities are long-term investments that can be suitable for retirement funding, they are subject to market fluctuations and investment risk, including the possibility of the loss of the principal. Annuities also come with a range of fees and charges. You should therefore always read the prospectus carefully and consult a financial professional before purchasing an annuity.