When planning for retirement, it’s essential to consider various investment options that can provide financial security and tax advantages. One such option is an annuity. In this article, we’ll explore the concept of annuities, their tax benefits, and how they can be a valuable addition to your retirement strategy. For personalized mortgage services, contact O1ne Mortgage at 213-732-3074.

What Is an Annuity?

An annuity is a contract between you and an insurance company that guarantees lump-sum or regular payments, often for life. Annuities come in many different types, but for tax purposes, it’s crucial to understand the difference between qualified and nonqualified annuities:

• Qualified Annuities: Purchased with pretax dollars and often held in retirement accounts such as 401(k)s or IRAs.
• Nonqualified Annuities: Purchased with after-tax dollars and usually held outside of regular retirement accounts.

Annuities can also be immediate or deferred:

• Immediate Annuities: Convert a lump sum into payments that begin right away.
• Deferred Annuities: Have an accumulation phase during which payments and interest add up, followed by a starting date after which regular payments are made.

Tax Advantages of Annuities

The IRS offers several tax benefits that can make annuities useful for retirement savers. Here are a few to consider:

Annuities Grow Tax-Deferred

Any interest or capital gains you earn while your money is invested in an annuity aren’t taxable in the year you earn them. Instead, you’ll be taxed on distributions or earnings when you receive payments. This allows your money to stay invested and continue to grow.

Save for Retirement Beyond Contribution Limits

If you’ve maxed out your annual IRA and 401(k) contribution limits, you can still purchase an annuity outside your retirement accounts to save even more for retirement. However, any retirement accounts you use to hold annuities are still subject to contribution limits.

Annuities Can Be Rolled Into a Roth

Roth annuities are funded with after-tax dollars, just like Roth IRAs. If you hold annuities inside Roth accounts, qualified distributions are untaxed. You may also convert traditional IRA or employer-sponsored retirement account annuities to a Roth, though the amount you convert may be subject to tax.

Tax-Timing Options

Annuities offer flexibility in tax planning:

• Use pretax dollars to purchase a qualified annuity if you need to reduce your taxable income now.
• Defer taxes on your earnings if you expect to be in a lower tax bracket in retirement.
• Add a nonqualified annuity or Roth annuity to reduce or eliminate taxes on your distributions when you retire.

How Are Qualified Annuities Taxed?

Qualified annuities are funded with pretax dollars and are often held within 401(k) retirement or traditional IRA plans. Contributions are typically tax-deductible, and distributions are fully taxable as ordinary income. You must begin taking required minimum distributions from a qualified annuity beginning at age 73, unless it’s held within an employer-based retirement plan and you’re still employed there.

How Are Nonqualified Annuities Taxed?

Nonqualified annuities are funded with after-tax income, so the money you use to fund your original investment has already been taxed. When you withdraw money from a nonqualified annuity, you’ll owe taxes only on the portion of your payment that represents earnings. Your earnings are taxed as ordinary income.

What Is the Exclusion Ratio?

The exclusion ratio is the portion of a nonqualified annuity payment that is not taxed. For example, if you invest $50,000 in a nonqualified annuity and expect a total return of $75,000, you’ll ultimately pay taxes on the $25,000 in earnings but not the distribution of your original $50,000. The exclusion ratio helps you calculate the taxable portion of your annuity payment(s) for as long as you expect to receive payments.

Taxes on Annuity Withdrawals

If you withdraw funds from an annuity before you reach age 59½, you may have to pay a 10% early withdrawal penalty tax to the IRS. The 10% penalty typically applies to the (taxable) earnings portion of a nonqualified annuity distribution and the entire withdrawal from a qualified annuity. There are a few IRS exceptions that may help you avoid the penalty tax. Talk to your tax advisor to see whether you might qualify.

The Bottom Line

Annuities can be useful for retirement tax planning, but understanding their tax benefits and how to deploy them can be complex. You may want to enlist the help of a retirement planner, financial advisor, and/or a tax professional to determine how annuities may fit into your larger retirement plan and current tax situation.

For expert mortgage services, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your financial future with confidence.