Income in retirement remains a hot-button issue for many pre-retirees and investors already in their golden years. With stock market volatility rising and bond prices dwindling, this has only gotten more pressing. To that end, annuities have gotten the nod from investors and policymakers as a solution.
And for good reason. Annuities offer the ability to provide steady income for a participant’s life. That is a huge win for many investors in the current environment.
However, annuities may come with some headaches that investors are not prepared for. And that is on the tax front. Not surprisingly, these complex products can come with some complex tax issues. For investors, understanding how these issues could play out is key when evaluating these products in their income plans.
Be sure to check the Retirement Channel to learn more about investing strategies to build up your nest egg.
Tax-Deferred Growth
There are numerous types of annuity products out there, but they really come down to two main flavors. One is designed to help you save money for retirement over time (deferred) and the other is designed to provide cash payments after paying a lump sum of money to the insurance company (income annuities).
Deferred annuities—whether they are variable, fixed or otherwise—offer some unique tax benefits during their accumulation phases. Here, just like a traditional 401k or IRA account, growth is tax-deferred. Dividends, interest, and capital gains are not owed as they happen in a given tax year and allow for additional compounding. The win is there are virtually no limits on deferred annuity contributions. You can only shove so much money into an IRA or 401k per year. This makes deferred annuities ideal for savers who have already maxed out their workplace retirement plans and IRAs.
The wrench in the machine comes when it’s time to withdraw money from an annuity. IRA and 401k accounts are pretty simple to understand regarding taxes: withdrawals are taxed at ordinary income rates. However, with deferred annuities, there are numerous other factors.
Don’t forget to check out this article to learn how the SECURE Act can impact annuities.
Qualified vs. Non-qualified
The key for taxation comes down to how you paid for the annuity. If you purchased the annuity using pre-tax dollars—such as within a traditional IRA or 401k—the annuity is considered a qualified annuity. In this instance, the tax rules governing the plan also govern the annuity within the plan. So, if you withdraw money from an annuity or set up monthly income payments, you will pay ordinary income taxes on the withdrawals.
Non-qualified annuities are those made with after-tax dollars such as a savings account or taxable brokerage account. The beauty is that you will not pay taxes on your contributions, just the growth portion of the annuity.
But this is where the complexity begins. The IRS uses ‘Last In, First Out’ rules when it comes to taxation of non-qualified annuity withdrawals. That is, the IRS requires you to use the growth portion first when making the withdrawal. So, if you invest $100,000 into a non-qualified annuity and it grows to $225,000, when you start making withdrawals, you are first pulling out the $125,000 in gains before touching the principal.
These gains are taxed at ordinary income rates rather than potentially more favorable long-term capital gains rates. Compounding this issue is if the annuity continues to gain in value during the withdrawal stage. Investors may never actually reach the tax-free portion of their annuity. Additionally, the IRS considers annuities irrespective of the type of retirement vehicles in which they reside. As such, withdrawals before age 59 ½ are subject to the normal 10% penalty for early distributions.
Income Annuities
Income annuities come with their own tax consequences. Like deferred annuities, income annuities purchased with qualified money are subject to the taxes of the account. So, payouts from an income annuity in a 401k are subjected to ordinary income rates.
For non-qualified money, taxes again get complicated. The IRS uses something called an ‘exclusion ratio,’ which is based on how much was invested, how much it has earned, and how long payments will last. Generally, the last portion is the estimated life span in retirement. Because of this, a non-qualified income annuity payment will feature both tax-free returns of principal as well as ordinary income taxed pieces.
Where it gets potentially complicated is if an annuitant lives longer than estimated. The tax-free principal is divided evenly among payouts until the estimated age. After that, any payouts from the annuity are 100% taxed as ordinary income. So, if the IRS estimates you will live to 90, but you live to 95, those last five years’ worth of payout from the annuity would be taxed at ordinary income rates.
Annuitizing a deferred non-qualified annuity into an income annuity allows investors to circumvent the previously mentioned Last in, First Out rules. However, they are then subject to the exclusion ratio tax rules.
Talking to a Tax Advisor
The end all, be all is that annuities can have pretty complex tax issues. And we have only scratched the surface. Understanding how they fit into a portfolio and how investors may be subject to taxes is an important part of the planning process. To this end, taking the time to talk to a financial or tax advisor seems prudent to run the various tax scenarios that come with potentially adding one to a portfolio.
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