Annuities which are primarily offered by insurance companies are the only financial product on the market specifically designed to convert a lump sum to a guaranteed income. As such, they are powerful tools for hedging against uncertainty and risk. But they also come with robust tax advantages as well.
The Power of Tax Deferral
Tax deferral is a powerful tool that an investor can use to compound potential returns over and above what you might gain using similar investments in a taxable account. Any tax you can put off paying to Uncle Sam is equivalent to taking an interest-free loan from the government and investing it.
For example, if you make a series of investments that generate $1,000 per year in the first year in interest income and you hold those in a taxable account (such as a bank CD aka Certificate of Deposit), you will likely have to pay $250-$280 to the IRS in income taxes.
You could only reinvest $720-$750 of that money and let it compound over time. By holding those same investments in a tax-deferred vehicle, however, you get the benefit of compounding the entire amount, year after year after year.
As investment mogul Warren Buffett has noted, this is the same as the government handing you that extra amount to invest with no payments and no strings attached, if the money stays in the annuity. Yes, you pay income tax on gains eventually, but you get to decide when subject to RMD (required minimum distribution) rules which I will cover below.
Annuity Taxation Basics
If the annuity owner is still living, they are taxed very similarly to traditional IRAs with nondeductible contributions and have many of the same tax advantages.
- There is generally no up-front tax deduction on premiums (unless you hold the annuity in an IRA).
- There is no capital gains tax. You can exchange from annuity to annuity as much as you like, using Section 1035 of the U.S. Tax Code, without worrying about capital gains or losses). If you just used mutual funds outside of a retirement account, you would have to pay capital gains taxes on any net gains each year.
- There are no taxes on dividend income.
- There is no tax on interest income.
- Distributions are taxed as ordinary income.
- You don’t pay taxes on the entire distribution — only the part attributable to growth from non-deductible contributions.
- Once you turn age 73, (as per the SECURE 2.0 Act of 2022) you must start taking RMDs (required minimum distributions) if the annuity is an IRA (aka qualified or pre-tax money). This age limit increases to age 75 in the year 2033.
Annuity Taxation at Death
The tax treatment of annuities depends on whether the annuity was still in the growth phase or began paying out income benefits. If the owner dies before the annuity starts paying an income, the beneficiary has several choices:
- Keep the annuity contract intact and treat it as his or her own (an option for surviving spouses only).
- Surrender the contract, take the cash immediately, and pay income taxes.
- Spread out withdrawals as the account MUST be emptied within 10 years of inheritance.
- Let the contract continue to grow tax-deferred for 10 years, and then take the entire annuity income at that time.
- Annuitize the inherited annuity and take payments over 10 years since death.
- You must decide within 60 days of inheritance.
If the annuity has already started paying out income, the beneficiary must continue to take the income at least as fast as the annuitant was taking income.
As you can see, there are many benefits to having annuities as part of one’s portfolio. We have access to over 100 annuities and software to identify the highest guaranteed interest rates.
For a quote or more information on annuities, feel free to reach out to me at Rob@InsuranceDoctor.us.