Is an annuity a good investment? Some tax advantages and disadvantages to know

Vaseline4 weeks ago

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Is an annuity a good investment? Some tax advantages and disadvantages to know

You’re in good company if you’ve seen the title of this piece and aren’t sure how an annuity works, let alone how it might affect your taxes. Despite being a potentially valuable retirement tool, data shows that annuities remain a mystery to many, including those nearing retirement age.

American College of Financial Services recently finder that annuities were the least understood retirement product among adults ages 50 to 75. That’s despite the fact that nearly half of working adults in that age group worry about running out of money in retirement, according to the Life Insurance Marketing and Research Association (LIMRA).

Meanwhile, while annuities aren’t right for everyone, they can provide a steady stream of retirement income that some experts say shouldn’t be overlooked. But like other financial investment products, annuities have advantages and potential pitfalls when it comes to taxes.

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Let’s break down some pros and cons.

What is an annuity?

Before delving into taxes, it helps to know some basics. An annuity is a financial arrangement that can turn your savings into a steady stream of income during retirement.

An annuity involves a contract with an insurance company where you give them funds either in a lump sum or through regular premiums. In return, the company commits to sending you payments that can last for a certain period of time or for life. It is important to note that an annuity is not life insurance or a savings certificate.

Annuities can be more immediate or deferred and come in different types with distinct features and risks. Different interest rates and sometimes complex administrative and other fees are also involved.

Fiscal advantages of the annuity

The taxability of annuity payments generally depends on whether pre-tax or after-tax money was used to fund the annuity, but annuities offer some tax advantages.

Note that these are the general potential advantages of annuities. Whether an annuity is a good investment for you will often depend on your financial situation.

Tax-deferred growth. Your investment earnings grow tax-deferred. Contributions to non-qualified annuities are not deductible, but you pay no taxes on the earnings until you withdraw the money. As a result, the amount may worsen over time.

Lower federal tax bracket. You may be in a lower federal income tax bracket when you start taking annuity distributions, so you pay less tax on the distributions.

Payment flexibility. Annuities offer various payment options, allowing you to structure withdrawals according to your financial situation. This can help you manage your taxable income, potentially reducing your tax burden.

Disadvantages of annuity tax

Note that these are potential downsides to annuities, generally speaking. Whether an annuity is a good investment for you will often depend on your financial situation.

A key tax challenge with annuities involves tax rates. When you withdraw money from an annuity, the earnings are taxed as ordinary income. So you may pay more tax than other types of investments that benefit from lower capital gains tax rates.

Then, early withdrawal penalties must be considered. If you withdraw funds from the annuity or cancel it before age 59 1/2, you’ll likely face a 10% early withdrawal penalty and ordinary income taxes. There are some exceptions to avoid the potential tax penalty.

Complex tax rules. The tax rules can be challenging, especially when distinguishing between qualified and non-qualified annuities.

Qualified annuities are funded with pre-tax money, giving you a tax break now but forcing you to pay taxes on withdrawals later.
Nonqualified annuities use after-tax dollars, so you don’t get an immediate tax benefit, but you owe taxes on the earnings when you withdraw.

Qualified annuities—often part of retirement plans like 401(k)s and 403(b)s—have IRS-mandated contribution limits, while nonqualified annuities do not. Also, with a non-qualified annuity, any 10% early withdrawal penalty would only apply to the earnings, not the principal.

Also, nonqualified annuities do not require you to take required minimum distributions (RMDs). However, the IRS requires owners of most qualified annuities to take distributions, generally beginning at age 73.

QLAC?

If you’re concerned about required distributions, there’s a type of annuity called a Qualified Longevity Annuity Contract (QLAC) that you purchase by transferring funds from your qualified retirement account. A longevity contract basically allows you to set aside a portion of your retirement savings and deal with the IRS tax implications later.

For 2024, you can use up to $200,000 (lifetime limit subject to inflation adjustment) from your 401(k), traditional IRA or other eligible retirement savings account to purchase a longevity contract. If you’re married, you can both use your respective accounts to buy QLACs separately.

A longevity contract allows you to defer some required distributions until you reach age 85. But remember, defer taxes, don’t avoid them. QLAC payments are taxed as ordinary income.

Annuities: Conclusion

The different rules, fees and features of annuities can be challenging. However, you must navigate these requirements effectively to avoid unexpected tax liabilities.

As always, it’s good to consult a trusted and qualified financial or tax planner to help you evaluate the tax implications and decide whether an annuity fits your retirement strategy.

Note: This article first appeared in the Kiplinger Retirement Report, our popular monthly periodical covering the key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement tips this is on the money.

Vaseline4 weeks ago

0 4 minutes read

Vaseline

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