One of the most attractive features of using annuities for retirement and/or estate planning may be the tax advantages that annuities provide. In some cases, however, depending on your tax situation, the tax advantages of annuities may not be sufficient to justify the purchase of annuities. As a result, it is extremely important to consult a tax advisor and/or an experienced financial planner before you purchase an annuity, in order to determine how the tax advantages and/or implications of annuities will affect you and your family.
If you purchase an immediate annuity with after-tax income, a portion of each periodic payment that you receive is from the principal sum that you originally invested in the annuity. Therefore, you are receiving a portion of your payments free of any taxes. The downside of this tax-free income, however, is that you have to use complex IRS annuity life expectancy tables in order to calculate the portion of your payments that is non-taxable, and that which is taxable. On the other hand, if you purchase an annuity through another retirement plan, such as an IRA or a 401(k) plan, the payments are fully taxable.
You’ll also need to keep in mind that annuity income is taxed at regular income tax rates, aside from the portion of the principal paid out in immediate annuity payments. This can be a rather high tax rate, depending on your income and assets, which can be up to 35%. Plus, income tax on annuity income can be much higher than the dividend tax rates that apply to mutual fund accounts. Furthermore, some states assess additional taxes on annuity income, which only add to the tax burden resulting from an annuity purchase, depending on your state’s laws.
Annuities can also result in an unexpected tax burden for your beneficiaries or surviving family members. Annuities are subject to federal estate taxes, as well as income taxes, which are responsibilities that carry over to your beneficiaries upon your death.
There are some other tax implications of annuities that can provide a significant tax advantage; when you purchase an annuity, all earnings on your investment are tax deferred. This means that you don’t pay any income taxes on the earnings, such as interest, dividends, and capital gains, until you withdraw them from the annuity. You must wait to begin receiving payments from your annuity until after you have reached 59 ½ years of age, or you may be assessed a 10% penalty, which would clearly undermine any tax savings from your investment in the annuity. Therefore, particularly when you allow your annuity investment to grow tax deferred for a lengthy period of time, such as for ten or fifteen years, you may experience significant earnings on your investment. Additionally, since you are able to control the rate at which you receive taxable income from the annuity, you will not be subject to a suddenly large tax liability.
Another tax-related downside to annuities, however, is the possibility that you will need to withdraw from your annuity investment earlier than you had planned. If you must withdraw funds from your annuity before you have reached 59 ½ years of age, you are subject not only to regular income taxes, but also to a substantial withdrawal tax penalty, which can be up to 10%, or even 25% in some selected situations.