Deferred annuities offer powerful tax advantages. While annuity tax rules aren’t too complex, understanding them and naming beneficiaries properly assures the maximum tax advantage.
Annuity interest is not taxed until it’s withdrawn. With a deferred annuity, the owner decides when to withdraw interest and pay taxes on it.
The flexibility to wait until you need the income has many advantages for the annuity owner, as well as the spouse and beneficiaries. Deferred annuities include fixed-rate, fixed-indexed, and variable annuities.
Other interest-paying investments such as money market accounts, savings accounts, certificates of deposit and bonds (except tax-free munis) create taxable income unless they’re held in a retirement account. You must claim the interest earnings as income on your 1040 form and pay tax even if you don’t withdraw or use the income.
Compounding occurs when interest is paid on previously earned interest. So, let’s suppose you have a CD that’s paying 3.0%. All future interest will be compounded on the total of principal and accumulated interest.
But, unless your CD is in an IRA or another tax-qualified account, you’re not really getting 3.0%. For example, if you’re paying 25% in combined federal and state income taxes you’d be earning only 2.25% net.
With a deferred annuity, if you’re earning 3.0%, you’ll keep it all for compounding. By allowing the annuity interest to remain untaxed and in your account, your money will grow and compound faster than money in a taxable account earning the same before-tax rate. At 3.0%, compounded annually, $10,000 will grow to $13,439 in 10 years. At 2.25%, you’d have $12,492. The higher your tax bracket and the longer you defer, the bigger the advantage.
Annuities can be purchased with pretax funds or after-tax funds. You can place an annuity within an IRA, Roth IRA, 401(k), or 403(b) plan. Such annuities are sometimes called qualified annuities.
Nonqualified annuities are purchased with funds that have already been taxed. In other words, you hold it in a taxable account instead of within a retirement account.
Annuities held in standard IRAs are subject to the Required Minimum Distribution (RMD) rules, just like other IRA investments. This rule requires you to take withdrawals each year after you reach age 70 ½. Each withdrawal is fully taxable.
But nonqualified annuities are not subject to RMD rules, and that’s a big benefit. This lets interest continue to compound without tax until you withdraw it. For instance, if your annuity earns $1,000 of interest and you withdraw $200, you’ll only pay tax on $200. The balance, along with your principal, continues to compound tax deferred.
The interest credits and gains from all types of annuities are taxed as ordinary income, not long-term capital gain income. But your original investment (the principal) in a nonqualified annuity is not taxed when it is withdrawn.
Naming beneficiaries correctly extends tax advantages
If you’re married, your spouse does not have to pay taxes on an annuity when you die if you’ve named your spouse the primary beneficiary. Then, your spouse can assume ownership of your qualified or nonqualified annuity at your death and continue to earn tax-deferred interest.
Here are two examples.
1 – Jack Hill and Jill Hill are married and Jack has an annuity in his name. They have three children. Jack would name Jill Hill – Spouse, as his primary beneficiary. would then name their three children as contingent beneficiaries.
If Jack dies first, Jill will become the new owner of the annuity and their children will become the primary beneficiaries. If Jill dies first, Jack continues as the owner and the children become the primary beneficiaries.
2 – Jack Hill and Jill Hill are married and jointly own an annuity. The primary beneficiary designation should read surviving spouse and the contingent beneficiaries should be their three children.
Joint annuity owners should not name their children as primary beneficiaries. In this example, if either Jack or Jill passes away, annuity benefits would be payable to their children rather than the surviving spouse. And the accrued interest would be taxable.
Most often a single annuity owner will name their child or children or other relatives as primary beneficiaries. The next most common designation is to name a living trust as the beneficiary and allow the trust language to govern the payout.
Most insurers let adult children choose their payment option. There are three choices. Taking a lump sum means that all accumulated interest is taxable in one year. Under the five-year option, the beneficiary can take their share of the annuity over a five-year period and spread taxes over five years. This often leads to a lower tax payment. The third option is receiving benefits over the beneficiary’s life expectancy.
Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities.
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