It’s my annual “Taxes from A to Z” series! Next up:
An annuity is an insurance product that pays you each month for a specified term. The term can be based on your life span or a pre-determined number of years; if it’s based on a pre-determined number of years, it’s often called a years certain annuity or a term certain annuity.
It’s not unusual for a years certain annuity to pay out a larger monthly amount than an annuity which pays out over your life span – that makes it appealing for some folks. However, with a years certain annuity, there is the real possibility that you could outlive the term of the annuity, making it less attractive for retirement, depending on your other circumstances.
Annuities are typically funded with after-tax dollars. There’s no deduction for making a contribution to an annuity funded with after-tax dollars. However, there is a tax benefit: generally, funds inside an annuity grow tax deferred and are subject to tax at the time of distribution. When you receive your monthly payment, part of the payment is considered a return of previously taxed principal with no tax consequences. The remaining part of your payment (determined by a formula) is considered earnings and is taxed as ordinary income.
Annuities may also be funded as part of a qualified plan, like an IRA, 401(k) plan or other retirement plan. If so, the annuities are treated, for tax purposes, just like other qualified plans. That means that you receive a tax benefit upon funding and the earnings on your investment are not taxed until you make a withdrawal. The normal withdrawal rules apply.
If you decide to take an early payout from your annuity, you may be subject to a penalty. Typically, if you make withdrawals before you reach age 59 ½, you will be be taxed on the earnings (as ordinary income) 10% and subject to an early distribution penalty. Extra fees payable to the financial institution administering the annuity likely also apply.
(I know what you’re thinking: the general rules for annuities sound really similar to those for qualified plans. You’re right. The tax-deferred treatment is more or less the same.)
At death, an annuity payable during your life tends to wrap up, with nothing passing to your heirs. With a year certain annuity, if you die before the term expires, any remaining payments will be paid to your beneficiary and taxed accordingly.
The rules which govern annuities can be quite complicated – with good reason. There isn’t just one kind of annuity. Or two. Or three. In addition to the choice between life or years certain, you can opt for fixed or variable. Deferred or immediate. You can even combine choices. The number of options available make annuities attractive but also potentially tricky for tax purposes. For more information about the specific tax consequences of an annuity, be sure to check with your tax professional.
