What is a Tax-Deferred Annuity?
July 13, 2021 9 min read  This story originally appeared on Due    Just this morning I booked my room for an upcoming wedding. What Ive preferred when making a room reservation is that you arent charged until you check out. In other words, you need a card number to book the room but arent charged until a later date. Because it ensures that I set aside that amount in my bank account. That way, I can use my debit card or pay the balance off a credit card immediately. And, if for some reason I had to cancel the reservation, I dont have to go through the refund process. On the flip side, it would be nice to just pay for the room in advance so that you dont have to worry about it. You might find yourself in a pickle. Regardless, in a way, since I live and breathe annuities, this reminded me of a tax-deferred annuity. I know what youre thinking. Well, like not paying for your room until after your stay, you dont have to pay taxes on an annuity until you begin receiving payments. That might not have cleared things up. So, lets dive a little deeper here. Annuities are tax-deferred. That simply means that this lets your investments grow tax-free. That includes interest, capital gains, and dividends Once you make a withdrawal or start receiving annuity payments, however, youll have to pay taxes. That doesnt mean youre free-and-clear of taxes here. Youre still responsible for paying taxes on growth as ordinary income. Youre just postponing this until a later date. As with other types of annuities, a tax-deferred annuity is considered an investment vehicle. Its sold by insurance or annuity companies with the purpose of providing a guaranteed retirement income. And, like any other annuity, it offers fixed or variable rates of return. If you chose a fixed taxed annuity youll receive guaranteed interest, while a variable tax-deferred annuity will fluctuate. So, if you purchased a fixed annuity, such as the one offered from Due, and youre earning 3%, you keep all of that for compounding. In turn, that allows your money to grow faster than a taxable account, such as a CD. Whats more, the greater income youll have coming your way. Annuity taxation. As previously discussed, annuities are tax-deferred. However, these taxes will be determined by how you set up the annuity contract. And, that ultimately depends on whether or not the annuity is qualified or non-qulified. A qualified annuity is funded by pre-tax dollars. In other words, youre buying the annuity with with money that taxes havent been previously paid on. Examples would be a 401(k) or IRA. Since you havent paid taxes on the amount youve contributed, you are required pay tax on the full amount of any distributions. However, if you purcahsed an annuity with a Roth IRA or Roth 401(k), there are completely tax free as long ad certain requirements are met. With that in mind, it wouldnt hurt to set money aside sooner then later. The last thing you want is to be starring down a hefty tax bill when you begin recieing annuity payments. As for a non-qualified annuity, this is funded with post-tax dollars. As such, taxes on these annuity distributions will be assessed at the same rates as regular income. Overall, the amount youll be taxed will depend on your marginal tax rate. Also, with a non-qualified annuity, youve already paid tax on the money that youve contributed. That means youll only be taxed on a portion of the annuitys income. This is called the exclusion ratio. And, its dependent on principals earning, as well as the length of the annuity. The annuity payments youll receive at this point are fully taxable. Be aware that your state may have different rules regarding how it assesses state income tax on annuities. Instead of trying to figure this out on your own, discuss this with your accountant or tax advisor. The advantages of a tax-deferred annuity. As is the case for most annuities, a tax-deferred annuity can provide income for the remainder of an individuals life life. Regardless if its a fied or variable, your princiapl is protected. In addition to being protected against, it promises a minimum monthly payment. But, if your prefer, you could choose a lump-sum payment option. Overall, annuities typically perform better than other types of investments during turbulent economies. Moreover, the funds in a tax-deferred annuity will be compounded every year. And, once again, arent taxed until he withdraws them. That can be to your advantage if youre in a lower tax bracket  which isnt uncommon for retirees. An additional benefit is that not only does the principle earn interest, the interest earns interest too. But, wait, theres more! Unlike 401(k)s and IRAs, annuities have virtually no contribution limits. You may also have access to a range of annuity funds. And, theres no minimum required distributions at age 70 on after-tax contributions  The disadvantages of a tax-deferred annuity. While there a number of tax deferred annuities, they do have their drawbacks. For staters, tax-deferred annuities tend to have high maintenance fees. Because of this, they could more expensive than other investments. Well, mainly this is through riders  which are additional features or benefits you can add to your plan. The most common examples you can except would be annual, deposit, mutual fund management, and insurance fees. These fees accumulate and have the potential to reduce your profits that the annuity gains. With that in mind, when shopping for an annuity opt for low-load or no-load agreements. This means working with a company that doesnt pay commission fees to sellers. In turn, this keeps annual fees low. And, they may not hit you up with a surrender charge if you take your money out early. Piggbacking on that last point, since annuities are a long-term investment theyre not liquid. That doesnt make them a reliable source to handle an emergency. Moreover, if you do withdrawal funds early from the annuity anticpate large penalty fees. And, if you do this before the age of 59 , youll pay an additional 10% early withdrawal tax. Tax-deferred annuity FAQs. Yes. You still have to pay taxes on your annuity. Theres no way around that. However, you dont have to pay taxes until you make a withdrawal or being receiving your annuity payments. Heres where things get a little more complicated. If youve funded the annuty with pre-tax funds this is taxed an ordinary income. If you used post-tax money to fund the annuity then youll only pay taxes on the earnings. Your taxes will also be affected by how and when you withdraw funds from your annuity. As a general rule of thumb, if take money out of your annuity prior to age 59  you may pay a 10% penalty  but only on the taxable portion of the withdrawal. After the age of 59 , if you take a lump-sum withdrawal, as opposed to a recurring income stream, this will trigger the tax on your earnings. In other words, youll owe income taxes on that year. And, it will be on the entire taxable portion of the funds. If so, the IRS will consider the first and subsequent withdrawals to be interest. And, this will be subject to taxes. What truly matters, regardless of how you withdraw the money or the tax status comes down to it being a qualified or non-qualified annuity. With qualified annuities, youll pay taxes on the entire withdrawal amount. For non-qualified annuities, youll only pay income taxes on the earnings. When its time to receive your annuity payments, each payment will be considered earnings. As a consequence, they will be subject to income taxes. Yes. If someone has inherited an annuity they will have to pay taxes on it. Generally, youll owe income tax on the difference between the principal paid into the annuity the annuitys value when the owner died. However, this also depends on the payout structure, as well as the beneficiarys relationship. For example, if you inherit an annuity and opt for a lump-sum payment, taxes will have to be paid immediately. But, if you defer the payments, these will contine to grow tax-deferred. You wont like the answer. But, that depends on a couple of different factors. First is if you purchased the annuity with qualified (pre-tax) or non-qualified (post-tax) funds. Second, your tax bracket overall income at the time of purchasing the annuity may also guide your withholding strategy. That being said, speak with your financial or tax advisor to give you a more accurate ballpark figure. For professionals, such as teachers, you may have access to a tax-deferred annuity retirement plan. As explained by the TIAA, this is designed to complement your employers base retirement plan. Sometimes, a TDA plan is also referred to as a voluntary savings plan, a supplemental plan, a tax-sheltered annuity (TSA) or simply a 403(b) plan.  A key difference between this type of plan and a typical annuity is that there are contribution limits. As of 2021, the most you can contribute to your TDA is $19,500. If youre over the age of 50, you can play catch-up with an additional $6,500 contribution limit. The bottom line. A tax-deferred annuity can be a win-win in terms of retirement planning and investing. But, thats only if you and an annuity are match-made in heaven. At the minimum, this means that youve maxed out your other retirement contributions, are in a high tax bracket, and can wait to receive payments. appeared first on Due.