Tax Treatment of Annuities

Throughout your retirement planning process, you will probably start to talk to friends or relatives who have already experienced this major life change. It’s a good idea to get input from those with experience. But you’ll probably notice something interesting: Each of these people accomplished (or didn’t accomplish, as the case may be) their retirement goals in a different way. One rule of retirement planning is that there is no income solution that works perfectly for everyone.

Not only do people differ with regard to lifestyle and income needs, but they also fall into different tax brackets. Therefore, the tax implications of your retirement income choices become an important part of the overall puzzle.

If you’re considering annuities as a potential part of your plan, one thing to remember is that there are two main types of annuity. The primary difference between them is how they are taxed.

The first option is a qualified annuity. You can purchase this type of annuity with pre-tax money, and it is often offered as an option within your employer-sponsored retirement plan or IRA. Because you purchase this type of annuity with untaxed income, distributions from the contract are taxed as regular income once you reach retirement and begin withdrawals. This type of annuity might appeal to you for certain reasons, but it won’t offer any tax benefits separate from those already offered by your retirement fund.

The other option is a non-qualified annuity. These are purchased with after-tax dollars, outside of your employer-sponsored retirement plan or IRA. The income you use to purchase this annuity has already been taxed, so only the earnings (interest) within the annuity will be taxed when you begin distributions. These are calculated on a “Last In, First Out” (LIFO) structure. Distributions are taken first from accrued interest, and taxed as regular income. Once you’ve used up the earnings within the contract, distributions are based on the original investment and are not taxed. Therefore, a non-qualified annuity is a way to establish some tax-free income in retirement, although the first distributions will be subject to taxes.

This blog simply provides an overview of two annuity structures. But annuities are an incredibly complicated financial product, and many different sub-types exist. Call us for an appointment if you want to learn more about annuities.