When planning for retirement, an annuity investment may be the ideal solution for anyone who wants to plan for a steady stream of income until their death. With many people living well into their 90s or even 100s, the chances of outliving retirement savings are a very real concern for many retirees. Annuities solve that problem by providing a steady and never-ending stream of income until the annuity owner dies.
In addition to the peace of mind an annuity can bring, the credited earnings on an annuity are received tax deferred. This means that even if income taxes continue to rise, the income received from an annuity will be received without paying income tax. For these two reasons, purchasing an annuity is an appealing solution for many who are planning for retirement.
Non-Qualified Annuity Taxation
There are two phases in an annuity timeline: the accumulation phase and the income phase. Unless an annuity is purchased in one lump sum, payments are usually made over a period of time. During this time, the annuity is accumulating a credit that will later be paid when the owner enters retirement or on some other agreed upon beginning time.
During the accumulation phase:
- Earnings credited on the funds in a deferred annuity are tax deferred. This means that when the annuity grows, the earnings are not taxed while they remain in the annuity.
- Withdrawals from a deferred annuity during the accumulation phase are treated as taxable income, but only for the amount that is above the principal amount. If the withdrawals exceed any earnings, then that portion of the withdrawal is considered a non-taxable return of principal and no taxes are due.
- If withdrawals are made before age 59 ½, a hefty 10 penalty tax may be imposed unless under certain condition. This 10% penalty tax is in addition to the income tax on the withdrawal.
- During the accumulation phase, if the annuitant dies, the value of the deferred annuity is generally included in the annuitant’s estate, to the extent of the deceased annuitant’s proportional contribution to the annuity purchase price.
During the Income Phase:
- Based on the annuitant’s life expectancy, the annuity purchase price is then returned to the annuitant in equal tax-free amounts over an estimated period of time.
- In the year received, a portion of each payment that is in excess of the tax-free return of the purchase price is taxable as income tax.
- The balance is taxable when it is received that is over and above the portion of the principal amount.
- At death, the annuity’s present value is generally included in the estate, to the extent of the deceased annuitant’s proportional contribution to the annuity purchase price.
Advantages and Disadvantages of an Annuity
An annuity is a wonderful way to save for retirement on a tax-deferred basis. It can be thought of as a personal “pension” plan. However, as with any investment, there are potential advantages and disadvantages of an annuity.
Advantages to an annuity include:
- Earnings on annuity premiums are tax deferred as long as they remain in the annuity. A tax deferred investment, when compared to investments that are taxed each year, have the potential for accumulating significantly higher amounts of money over time.
- In order to ensure that a person does not outlive their retirement income, an annuity can be used to provide the steady source of retirement income.
- There are no limits to contributions made to an annuity. An IRA or employer-sponsored retirement plan places annual limits on contributions made yearly. An annuity allows a person to contribute as much as they want.
- Depending on the contract, there is not a certain date in which annuity income payments must begin. This provides a retiree the flexibility to defer payments until they need the income. With a 401(k), payments must begin no later than age 70. If a person wants to work past age 70, they can simply allow their annuity investment to grow.
- If a person dies while there is still value left in the annuity, the death benefit passes directly on to a beneficiary without having to go through the lengthy and sometimes expensive probate process.
- Creditors cannot make a claim on an annuity in most states.
Disadvantages of an annuity include:
- After-tax dollars are used for premiums meaning that taxes must be taken out first on income used to purchase an annuity or pay premiums.
- A deferred annuity cannot have early withdrawals made without penalty. If an annuity is surrendered or withdrawals made before income payments begin, the amount surrendered or withdrawn may be subject to a charge if made within a certain number of years after the annuity is initially purchased.
- If the annuity is surrendered or withdrawals made before the owner reaches age 59 ½, a 10% federal penalty tax must be paid. There are certain exceptions to this rule.
- The gains from investment are subject to ordinary income tax rates instead of the lower capital gains tax rate.
- Once the payments from an annuity begin, the contract will state whether the payment amount can be changed, whether any amounts can be withdrawn, and if there are any penalties or fees associated with these items.
With the complexity of an annuity, it is advisable to contact an expert financial advisor and discuss your personal expectations, needs, income, and desires for retirement. Annuities are a great tool to bring a retiree peace of mind, but educating yourself first and discussing your individual case with a financial advisor is the best route to a happy, satisfying, and long-lived retirement. Get the most out of your investments and retirement with a wide range of investments in your retirement portfolio.