How are Annuities Taxed? Qualified vs non-qualified tax impact
How Are Annuities Taxed?
Understanding annuities and specifically how they fit into a tax efficient retirement withdrawal plan is a common pain point with many people we talk to.
Annuities are commonly sold with an insurance salesman talking up the benefit of tax deferred growth. And that is true to some extent. While you are saving into these annuities you will not be subject to taxes on the growth of the investments, dividends, or interest. However, this benefit is useless if you are using retirement savings from an IRA or 401(k) to purchase the annuity since those accounts are already tax deferred.
However, what doesn’t get talked about enough is that this tax deferral comes at the cost of potentially much higher taxes later in retirement as you begin to withdrawal money from the annuity.
To understand your tax liability from an annuity, you need to know what type of annuity you have. There are 2 main types of annuities that have very different tax implications.
If you have a qualified annuity, this investment was funded with pre-tax savings. Maybe from a 401(k) or traditional IRA. Any withdrawals from a qualified annuity will be taxed at your ordinary income rate.
If you have a non-qualified annuity, it was funded with after-tax dollars. The money you used to initially fund the annuity is your basis and is withdrawn without tax consequences.
However, any growth on the investments in the account will still be taxed at ordinary income rates. When you take any withdrawals or you actually annuitize the annuity and begin receiving fixed payments, a portion of your payment will be taxable, and a portion will not.
We help our clients determine the role an annuity plays in their financial plan, and develop a tax efficient way to get money out of the annuity, or otherwise utilize it in your retirement plan.
These are complicated investments with some potential tax pitfalls if managed poorly, so please reach out if you have questions on an annuity you own or are considering.