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This story originally appeared on Due
Just this morning I booked my room for an upcoming wedding. What I’ve preferred when making a room reservation is that you aren’t charged until you check out. In other words, you need a card number to book the room but aren’t charged until a later date.
Why do I prefer this? Because it ensures that I set aside that amount in my bank account. That way, I can use my debit card or pay the balance off a credit card immediately. And, if for some reason I had to cancel the reservation, I don’t have to go through the refund process.
On the flip side, it would be nice to just pay for the room in advance so that you don’t have to worry about it. I mean what if for some reason you spent the money you’ve set aside? You might find yourself in a pickle.
Regardless, in a way, since I live and breathe annuities, this reminded me of a tax-deferred annuity.
What is a tax-deferred annuity?
I know what you’re thinking. What exactly is the parallel between a hotel reservation and annuities? Well, like not paying for your room until after your stay, you don’t have to pay taxes on an annuity until you begin receiving payments.
That might not have cleared things up. So, let’s dive a little deeper here.
Annuities are tax-deferred. That simply means that this lets your investments grow tax-free. That includes interest, capital gains, and dividends Once you make a withdrawal or start receiving annuity payments, however, you’ll have to pay taxes.
That doesn’t mean you’re free-and-clear of taxes here. You’re still responsible for paying taxes on growth as ordinary income. You’re just postponing this until a later date.
As with other types of annuities, a tax-deferred annuity is considered an investment vehicle. It’s sold by insurance or annuity companies with the purpose of providing a guaranteed retirement income. And, like any other annuity, it offers fixed or variable rates of return.
If you chose a fixed taxed annuity you’ll receive guaranteed interest, while a variable tax-deferred annuity will fluctuate. So, if you purchased a fixed annuity, such as the one offered from Due, and you’re earning 3%, you keep all of that for compounding. In turn, that allows your money to grow faster than a taxable account, such as a CD. What’s more, the greater income you’ll have coming your way.
As previously discussed, annuities are tax-deferred. However, these taxes will be determined by how you set up the annuity contract. And, that ultimately depends on whether or not the annuity is qualified or non-qulified.
A qualified annuity is funded by pre-tax dollars. In other words, you’re buying the annuity with with money that taxes haven’t been previously paid on. Examples would be a 401(k) or IRA. Since you haven’t paid taxes on the amount you’ve contributed, you are required pay tax on the full amount of any distributions. However, if you purcahsed an annuity with a Roth IRA or Roth 401(k), there are completely tax free as long ad certain requirements are met.
With that in mind, it wouldn’t hurt to set money aside sooner then later. The last thing you want is to be starring down a hefty tax bill when you begin recieing annuity payments.
As for a non-qualified annuity, this is funded with post-tax dollars. As such, taxes on these annuity distributions will be assessed at the same rates as regular income. Overall, the amount you’ll be taxed will depend on your marginal tax rate.
Also, with a non-qualified annuity, you’ve already paid tax on the money that you’ve contributed. That means you’ll only be taxed on a portion of the annuity’s income. This is called the “exclusion ratio.” And, it’s dependent on principal’s earning, as well as the length of the annuity.
What if you live past your life expectancy? The annuity payments you’ll receive at this point are fully taxable.
Be aware that your state may have different rules regarding how it assesses state income tax on annuities. Instead of trying to figure this out on your own, discuss this with your accountant or tax advisor.
The advantages of a tax-deferred annuity.
As is the case for most annuities, a tax-deferred annuity can provide income for the remainder of an individual’s life life. Regardless if it’s a fied or variable, your princiapl is protected. In addition to being protected against, it promises a minimum monthly payment. But, if your prefer, you could choose a lump-sum payment option. Overall, annuities typically perform better than other types of investments during turbulent economies.
Moreover, the funds in a tax-deferred annuity will be compounded every year. And, once again, aren’t taxed until he withdraws them. That can be to your advantage if you’re in a lower tax bracket — which isn’t uncommon for retirees. An additional benefit is that not only does the principle earn interest, the interest earns interest too.
But, wait, there’s more!
Unlike 401(k)s and IRAs, annuities have virtually no contribution limits. You may also have access to a range of annuity funds. And, there’s no minimum required distributions at age 70½ on after-tax contributions
The disadvantages of a tax-deferred annuity.
While there a number of tax deferred annuities, they do have their drawbacks. For staters, tax-deferred annuities tend to have high maintenance fees. Because of this, they could more expensive than other investments.
How are these fees are assessed? Well, mainly this is through riders — which are additional features or benefits you can add to your plan. The most common examples you can except would be annual, deposit, mutual fund management, and insurance fees. These fees accumulate and have the potential to reduce your profits that the annuity gains.
With that in mind, when shopping for an annuity opt for low-load or no-load agreements. This means working with a company that doesn’t pay commission fees to sellers. In turn, this keeps annual fees low. And, they may not hit you up with a “surrender charge” if you take your money out early.
Piggbacking on that last point, since annuities are a long-term investment they’re not liquid. That doesn’t make them a reliable source to handle an emergency. Moreover, if you do withdrawal funds early from the annuity anticpate large penalty fees. And, if you do this before the age of 59 ½, you’ll pay an additional 10% early withdrawal tax.
Tax-deferred annuity FAQs.
Do you pay taxes on annuities?
Yes. You still have to pay taxes on your annuity. There’s no way around that. However, you don’t have to pay taxes until you make a withdrawal or being receiving your annuity payments.
Here’s where things get a little more complicated. If you’ve funded the annuty with pre-tax funds this is taxed an ordinary income. If you used post-tax money to fund the annuity then you’ll only pay taxes on the earnings.
Are taxes influenced by withdrawals?
Your taxes will also be affected by how and when you withdraw funds from your annuity. As a general rule of thumb, if take money out of your annuity prior to age 59 ½ you may pay a 10% penalty — but only on the taxable portion of the withdrawal.
After the age of 59 ½, if you take a lump-sum withdrawal, as opposed to a recurring income stream, this will trigger the tax on your earnings. In other words, you’ll owe income taxes on that year. And, it will be on the entire taxable portion of the funds.
What if you don’t touch the money in your annuity account? If so, the IRS will consider the first and subsequent withdrawals to be interest. And, this will be subject to taxes.
What truly matters, regardless of how you withdraw the money or the tax status comes down to it being a qualified or non-qualified annuity. With qualified annuities, you’ll pay taxes on the entire withdrawal amount. For non-qualified annuities, you’ll only pay income taxes on the earnings.
When it’s time to receive your annuity payments, each payment will be considered earnings. As a consequence, they will be subject to income taxes.
Do beneficiaries pay taxes on inherited annuities?
Yes. If someone has inherited an annuity they will have to pay taxes on it. Generally, you’ll owe income tax on the difference between the principal paid into the annuity the annuity’s value when the owner died.
However, this also depends on the payout structure, as well as the beneficiary’s relationship. For example, if you inherit an annuity and opt for a lump-sum payment, taxes will have to be paid immediately. But, if you defer the payments, these will contine to grow tax-deferred.
How much should you withhold from your annuity?
You won’t like the answer. But, that depends on a couple of different factors. First is if you purchased the annuity with qualified (pre-tax) or non-qualified (post-tax) funds. Second, your tax bracket overall income at the time of purchasing the annuity may also guide your withholding strategy.
That being said, speak with your financial or tax advisor to give you a more accurate ballpark figure.
What’s a tax-deferred annuity (TDA) plan?
For professionals, such as teachers, you may have access to a tax-deferred annuity retirement plan. As explained by the TIAA, this is “designed to complement your employer’s base retirement plan. Sometimes, a TDA plan is also referred to as a voluntary savings plan, a supplemental plan, a tax-sheltered annuity (TSA) or simply a 403(b) plan.”
A key difference between this type of plan and a typical annuity is that there are contribution limits. As of 2021, the most you can contribute to your TDA is $19,500. If you’re over the age of 50, you can play “catch-up” with an additional $6,500 contribution limit.
The bottom line.
A tax-deferred annuity can be a win-win in terms of retirement planning and investing. But, that’s only if you and an annuity are match-made in heaven. At the minimum, this means that you’ve maxed out your other retirement contributions, are in a high tax bracket, and can wait to receive payments.