Tax season is here, and most folks are starting to wonder what they need to account for, which accounts are subject to taxes, and how their life insurance and annuities factor into the tax filing picture. If you aren’t already familiar with the general rules for annuities, then the guidelines surrounding annuities and taxes might quickly become overwhelming. However, the more you understand about how taxes impact your financial plans, the better off you are from a strategy and financial standpoint.
Quick Links
- What is an Annuity?
- Are Annuities Taxable?
- Annuities and Taxes on Withdrawals and Payments
- Understanding Section 1035 for Tax-Free Exchanges
- Death Benefits and Estate Tax Considerations
- Find Financial Security with Annuities
What is an Annuity?
Annuities are, essentially, scheduled payments. When it comes to annuities contracted through an insurance company, clients typically pay either a lump sum or make several payments which are then redistributed to the client at a later date, which are immediate and deferred annuities, respectively. These payments are then distributed based on pre-established increments using the initial client deposit.
In addition to immediate annuities, policyholders have the option of deferred annuities as well. With a deferred annuity, the initial funds can grow tax-deferred until a predetermined payout period begins, typically in retirement. This strategy helps individuals secure a stable income stream during their post-employment years, ensuring financial stability and peace of mind as they enjoy their retirement.
As a result, annuities offer a balance between long-term growth potential and the security of a guaranteed income, making them a valuable choice for anyone looking to enhance their retirement income strategy.
Are Annuities Taxable?
The simple answer is yes and no. Well, that’s not so simple, but thankfully the explanation isn't too complicated. First, annuities grow tax-deferred, which means there are no taxes until you make a withdrawal from the account.
But, withdrawals from an annuity contract will eventually be subject to income taxes. The details on these taxes vary depending on the type of annuity you have as well as how and when you access your funds. So, there are two kinds of annuities to be considered.
- Qualified annuities are those that are funded with pre-tax money. Because no taxes have yet been paid on these funds, when it comes to qualified annuities, the entire amount, both the principal and earnings, is taxable.
- Non-qualified annuities are funded with post-tax money and so only the earnings on the account are taxable.
When it comes to distributions, the tax treatment varies between qualified and non-qualified annuities. In qualified annuities, distributions are subject to regular income tax. These are commonly associated with employer-sponsored retirement plans like 401(k)s or IRAs.
On the other hand, non-qualified annuities allow for a partial exclusion of earnings from taxation during withdrawals. The exclusion is based on an "exclusion ratio" calculated by dividing the investment in the contract by the expected return.
Annuities and Taxes on Withdrawals and Payments
In addition to understanding how annuities are taxed, and get the full picture, it’s important to understand a few other requirements regarding both qualified and non-qualified annuities.
For example, qualified annuities, because they have not yet been taxed, are subject to required mandatory distributions (RMD). More specifically, the year you turn 73 you must begin taking RMDs unless the annuity is an employer plan and you are still employed, as an employee. This does not apply to business owners who sponsor their own annuities.
In contrast, non-qualified annuities function much like a ROTH IRA and do not require RMDs. However, both qualified and non-qualified annuities are subject to penalties or taxes for early withdrawals.
Any annuity withdrawals made before you reach age 59½ may be subject to a 10% early withdrawal penalty tax. When it comes to qualified annuities, that means the entire withdrawal is subject to the penalty tax. For non-qualified annuities, only the earnings or interest are subject to the tax. On top of that, many carriers and providers also charge a penalty fee.
Understanding Section 1035 for Tax-Free Exchanges
Section 1035 of the Internal Revenue Code outlines a tax-free exchange mechanism for anyone holding existing annuities. This allows policyholders to transfer funds from one annuity to another without facing immediate tax consequences.
When conducting a Section 1035 exchange, it's crucial to ensure that the transaction meets specific IRS guidelines. Both the original and new annuities must be of the same "type," meaning they share certain characteristics, such as being fixed, variable, or indexed. Additionally, the policyholder must directly transfer the funds from the old annuity to the new one, avoiding any personal receipt of the funds to maintain the tax-deferred status.
As a result of Section 1035, annuitants can make the most of the flexibility of annuities by adjusting their annuity investments over time while providing an avenue to adapt to changing financial needs.
However, it's always best for policyholders to consult with tax professionals or financial advisors to ensure compliance with IRS regulations and make informed decisions tailored to their specific financial goals.
Death Benefits and Estate Tax Considerations
What happens when an annuitant passes away before receiving the full value of their annuity? Well, much like life insurance, annuities offer a unique advantage in providing a financial safety net for beneficiaries upon the death of the annuitant.
When the annuitant passes away, the designated beneficiaries receive the death benefit, which is often a lump sum payment or a series of payments, depending on the annuity structure. And, beneficiaries are required to pay income taxes on death benefits from annuities.
In terms of estate taxes, the value of the annuity could be included in the annuitant's taxable estate, potentially subjecting it to estate taxes. To mitigate this, policyholders may choose to explore strategies such as naming a spouse as the primary beneficiary, as there is typically an unlimited marital deduction for estate taxes. Additionally, proper estate planning, including the use of trusts, can be used to manage estate tax exposure effectively.
Find Financial Security with Annuities
When you’re planning for your future, an annuity is a great option if you’re looking to supplement social security or other income streams and sources. Your money is allowed to grow, tax-deferred, and can then be distributed back to you when you need it most. And, if you have certain financial goals for retirement, such as buying a home or contributing to college tuition funds, then annuities are a great way to help you achieve them.
We understand that the details surrounding annuities and taxes are complicated. Between withdrawal penalties, qualified, and non-qualified annuities, there are a lot of features that need to be accounted for when compiling your tax information. That’s why it’s important to conduct thorough research into annuity products to ensure that you have a strong understanding of all of the intricacies involved and how they help you reach your long-term financial goals. Plus, a thorough understanding of annuities can make it a little bit easier to know what to expect when filing your taxes.
If you’re considering an annuity and wondering what options are not only available, but best for you, let the ELCO Mutual team connect you with an independent insurance agent who can offer you the expertise, advice, and products you need. Reach out today and let us help.
