Annuities can be a strong tax strategy to help maintain a higher portion of your retirement savings.
In this article, we’ll start with the basics of income tax, so you can understand how your pre- and after- tax investments affect your retirement fund.
We’ll then discuss why you should defer tax with an annuity, how to utilize deferred and immediate annuities as a tax strategy, and the intricacies of taxes for beneficiaries and gifting.
Income Tax 101
There are two key taxation points that you’ll need to know in order to properly defer tax with an annuity: deferred income tax and interest income.
Deferred Income Tax
The money that you use to purchase your annuity—including any money you contribute to a deferred annuity over the years—is either pre-tax or after-tax.
When you are earning money through an employer, money can be put into your retirement account directly from your paycheck. This means you have not received that money as income, so you will not yet be taxed on it. This is pre-tax retirement savings.
If you do not submit your retirement money through your employer or you’re self-employed, you usually take your income first. You will then be taxed on that income. This is considered after-tax investments in your retirement.
Pre-tax means that you are putting money into your retirement plan before the government pulls any income tax from those earnings. This means that your annuity investment can compound at a higher rate, because you are able to input a larger amount of pre-tax money in your annuity.
Example of deferring tax
For example, say you put in 10% of your $50,000 paycheck into your retirement account. If this is pre-tax, you will be investing the full $5,000. If this is after-tax, it gets slightly more complicated. Say your state’s income tax is 25% for the $50,000 tax bracket. Then you will have to first deduct the 25% income of your $50,000 paycheck.
That means you will instead invest 10% of $37,500, which means you will be investing $3,750. You will be invested $1,250 less after-tax, which means you will lose out on gaining interest on upwards of $1,000.
In this way, deferred tax with an annuity using pre-tax investments can help compound your money at a more significant rate.
This is a simplification of the income tax calculation. Nevertheless, it’s important to realize that if you input funds pre-tax, your investment will have more to compound from.
However, you will still have to pay income tax at the time of withdrawal in your retirement. If you input funds after-tax, your investment will not compound as exponentially, but you will not have to pay taxes on that money in retirement.
Basically, your annuity functions like an investment. This means that you’ll be earning interest on that investment. That earned interest is considered “income.” Thus, you’ll be taxed for that interest with regards to income tax.
This tax will be applied when you withdraw this income from your annuity. This means that you can continue to accrue compounded interest on that annuity investment before the taxes are taken out.
Overall, you’ll need to remember two key points for deferred tax with an annuity:
- When you withdraw money from an annuity that was invested pre-tax, you will need to pay income tax on that withdrawal.
- If you withdraw money from your annuity that was invested after-tax, you will not need to pay income tax on that withdrawal.
- When you withdraw interest payments from your annuity, you will always need to pay income tax on that earned interest.
Now that you know how pre-tax and after-tax savings work, you can start to strategize your deferred taxes with an annuity.
Why Defer Tax With An Annuity
An annuity is, in essence, an investment account. However, annuities are also considered a form of life insurance. This blend of investment and insurance creates unique tax benefits (and intricacies).
When you put pre-tax money into your investment, you will compound your investment tax-free. This means that you’ll have a larger sum of money earning interest. The more you are holding in your investment, the higher your interest will be.
More interest means more money in your retirement fund. More money in your retirement fund, in turn, leads to a higher sum of interest. This means that a larger sum in your investment will cause it to grow at a faster pace.
For example, earning 1% on $10,000 each year will give you $100 in interest the first year. The second year, you would receive 1% on $10,100, which would equate to $101.
If you were to earn 1% on $20,000 each year instead, you would receive $200 in interest the first year.
The second year, you would receive interest on $20,200, which would equate to $202. The more you have saved, the more you’ll make.
In this way, you want to keep your money in your annuity as long as you can, so it will keep making money.
With an annuity, you don’t need to begin paying tax (and thus lowering your investment) until annuitization (when you begin receiving payments).
That means you can continue to grow your investment for years before you need to start paying the government.
Tax Bracket Change
When you begin to take payments from your annuity, you may be in a lower tax bracket than you are currently. Higher tax brackets have a higher income tax rate.
If you expect to be in a lower tax bracket during retirement, the income tax you pay will be lower than if you had been taxed on that same fund now while in a higher tax bracket.
Say that you are making $92,000 per year currently. You would be taxed at 28% on all your income.
If you were to pay income tax on your retirement investment now today you would be paying 28% of your earnings.
Let’s say in retirement, you make $37,000 per year from your retirement saving payouts and any other means of income, like part-time jobs.
This means you will be in the 15% tax bracket. Now, you will only be charged 15% of your annuity payouts as opposed to 28%.
At age 70 1/2, you usually have to start taking withdrawals from your retirement accounts, like 401(k)s and traditional IRAs.
This is called required minimum distributions (RMDs). The government wants to start receiving its due income tax on those funds.
With an annuity, you can actually avoid these minimum distributions for a longer period of time. This means you can continue to compound money in your investment for as long as you’d like. Your annuity payments can then be counted towards your RMD. Learn more about taking RMDs with an annuity here.
With an annuity, you can control when and how you are taxed. You begin paying taxes when you choose to withdraw or annuitize. This means that you can control what your taxes look like for your retirement savings.
Other Annuity Benefits
- Annuity guarantees income for life
- You can make unlimited contributions and investments to a deferred annuity
- You receive a guaranteed rate of return with a fixed annuity
- Certain annuities offer a death benefit for beneficiaries
In essence, deferring your taxes will help your investment grow faster and larger, so you can have more money and security during your retirement.
How To Defer Taxes With Immediate Annuity
An immediate annuity is when annuitization begins immediately after purchasing the annuity. You begin withdrawing monthly or annual payments instantly.
Oftentimes, immediate annuities are purchased with after-tax money because you’ve either withdrawn it from another retirement account or purchased it using your own savings.
In this case, you have already paid taxes on that income. In this way, you won’t have to pay taxes when you withdraw your original investment. But you will have to pay taxes on any interest.
Each monthly or annual annuity payment you receive is made up partially of interest payments and partially of your principal investment.
If you purchased your annuity after-tax, the IRS will tax you only on the capital gains or interest portion of the annuity payment.
If your immediate annuity payout is higher than your tax-free return of principal, then it is considered “taxable earnings.” The IRS will calculate what percentage of your return is tax-free based on your life expectancy.
This is in accordance with the exclusion ratio. The exclusion ratio is the portion of your return on investment that is tax-exempt, because it is considered a part of the initial investment and not capital gains.
Annuity payments then become fully taxable when the total amount of the investment is recovered; this basically means you outlive your exclusion ratio and life expectancy. Then, you’ll be taxed on all of your annuity payments.
Example of Exclusion Ration
For example, you purchased an immediate annuity with $100,000 and your annual payouts are $8,000. You are expected to live 20 more years. The IRS will divide the $100,000 investment by the 20-year expectancy.
This means that $5,000 is considered your return of principal. Thus, your taxes won’t apply to the full $8,000 payout.
You will only need to pay taxes on $3,000 of the “additional income” that is not part of your principal return.
However, that only applies to after-tax immediate annuities. Some immediate annuities can be purchased with pre-tax money.
This usually occurs if you are transferring your money from one retirement plan to the annuity without withdrawing from the bank.
In this case, the entirety of your annuity payout will be considered income and taxed as such. In the example above, you would pay income tax on the full $8,000 payout.
How To Defer Taxes With Deferred Annuity
A deferred annuity is approached differently when it comes to taxes. You purchase a deferred annuity and begin receiving payouts at some point down the road.
You can continue to invest additional money until the point of annuitization. The money you invest in the annuity can either be pre-tax or after-tax.
The benefit of a deferred annuity is that it also defers your tax; you don’t start paying taxes until you begin withdrawing payouts.
Plus, you can also make tax-free exchanges to other variable deferred annuities, called a 1035 exchange, as long as you don’t withdraw any money.
There are two areas of taxation with a deferred annuity, based on how you purchase an annuity and how you withdraw money from that annuity.
Taxation Based On Purchasing
If you buy a deferred annuity with pre-tax money, then the entire balance is taxable. Any future payouts or withdrawals will be taxed as income.
If you buy a deferred annuity with after-tax funds, you will only be taxed on any interest or earnings that the investment receives. This especially holds true for variable deferred annuities.
Taxation Based On Withdrawal
If you withdraw your annuity in a lump sum:
- Annuity purchased pre-tax: you will pay income taxes on the entire lump sum
- Annuity purchased after-tax: you will pay income only on the earnings higher than the original investment
It’s not generally recommended to take a lump sum from an annuity, because the large withdrawal could put you in a higher tax bracket for that year.
You’ll actually get taxed more than you would if you took it in smaller withdrawals, so the years you deferred tax with an annuity would be for naught.
If you withdraw from your annuity in multiple sums that are not annuity payments, then the IRS will consider these withdrawals to be considered “earnings.”
Any additional withdrawals over the balance of your investment will be taxed, regardless of whether you purchased the annuity pre- or after-tax. (If you made the purchase of your annuity pre-tax, you will have to be income tax on all withdrawals.)
For example, you have invested $25,000 in a deferred annuity. After 20 years, the investment has increased in value by $10,000.
This means that if you decide to take any sort of withdrawals, the first $10,000 dollars you take in a lump or multiple sums are considered “taxable earnings” that came from the interest.
Any withdrawals you take after that $10,000 will not be taxed, because they will be considered part of your original after-tax annuity purchase investment.
The benefit of withdrawing in multiple sums is the ability to control your amount of distribution. You can control the amount of taxes you pay and when you pay them based on the payments you withdraw from your annuity.
Note that there is a tax penalty for any early withdrawals before the age of 59 1/2 with only the exception of the taxpayer dying or becoming disabled.
If you are receiving payouts from your annuity, your taxes will work in a similar way to an immediate annuity. Take a look above to learn more about exclusion ratio for deferred tax with annuity payouts.
Taxes For Beneficiaries
There are two key types of beneficiaries you can have on your annuity: an heir and a spouse. The withdrawal methods and taxes vary slightly between the two.
What happens if you die and the annuity goes to an heir before you’ve cashed out your annuity? This could happen before annuitization or with a death rider on your annuity.
In this case, the remaining portion is distributed to your beneficiaries as listed on the annuity. Annuities are a great option for those with heirs, because the beneficiaries can avoid probate.
This means they don’t have to prove a will and deal with the legal go-arounds. The annuity goes directly to the listed beneficiary almost immediately.
But unfortunately, beneficiaries still have to pay taxes on inherited annuities. Often, an inherited annuity will be considered in taxation twice: once as part of the deceased’s estate for the estate tax valuation and once as income tax for the beneficiary.
The heir then has three options to take remaining fixed annuity payouts:
- Take lump sum and pay all income taxes at once
- Make withdrawals over 5 years and pay income taxes on each withdrawal (the investment will still be allowed to grow tax-deferred during those 5 years)
- Wait five years so investment will grow tax-deferred, then take entire amount and pay all income taxes
If they inherit a lifetime annuity, the heir has two options:
- Annuitize the remaining interest over his or her life expectancy (which offers the lowest form of taxes)
- Begin withdrawals over a period and pay taxes on each payout
When one of the annuitant dies, the spouse has two options for the annuity: spousal continuation and receiving a death benefit.
Spousal continuation is when the joint annuity policy remains the same, in essence, but with only one annuitant. If the annuity was a joint annuity, meaning that both spouses could invest and receive payouts, then the annuity can continue as usual. The surviving spouse will continue to receive annuity payments and pay taxes on those withdrawals as discussed above.
Moreover, if this death occurs before the annuitization of the investment, the spouse can continue to hold the policy as a sole annuitant to preserve the tax-deferred growth until he or she is ready to begin withdrawals.
The second option is to take the death benefit. The death benefit is a lump sum paid to the spouse after the other annuitant’s death. This is considered a lump sum withdrawal, so it will be taxed when given to the spouse.
If the annuity was purchased pre-tax, the entire death benefit will be taxed upon withdrawal. If the annuity was purchased after-tax, only the difference between the cost of the original investment purchase and the given amount of the death benefit will be taxed as income.
In most cases, annuities are not included in taxable estate for marital allowance. This means that although an annuity may be considered as part of the estate when given to an heir, it is not necessarily considered a part of the estate valuation when left to a spouse.
Taxes On Annuity Gifts
If an annuity is given as a gift while the owner of the annuity is still alive, this money is technically being “withdrawn.” This means that it is considered income and will thus be taxed.
For taxation, the difference between cash surrender value of the contract and the original investment will be considered at time of transfer. The recipient may also have to pay gift taxes on top of the income tax.
Note that this “gifting” does not apply between spouses or former spouses.
The Bottom Line
You still have to pay taxes on the money you’ve made. But with an annuity, you control when and how you are taxed.
You can defer tax with an annuity to compound your gains each year, save more during your retirement, and control how your money goes to the government.
It’s time to take charge of your retirement savings and payments to the government.
Contact Sunpath Financial today to learn more about how deferring tax with an annuity, or find the annuity or investment that will ensure the most fruitful plan for your retirement!