If you want a guaranteed income from your investment, then an annuity policy is ideal. And, unlike some other types of financial instruments, annuities are tax-deferred. Alas, the taxman still cometh at some point after you withdraw payments. Understanding taxation terms, conditions and other issues will help you plan accordingly when you buy an annuity or any other retirement plan.
Types of annuities
There are two categories of annuities: qualified and non-qualified. Payouts are taxed differently from either one, so it’s essential that you choose the right option.
Taxation per category
If you use pre-tax money to fund the policy, it is referred to as a qualified annuity, CNN Money explains. Any of the payments coming from qualified annuities are subject to income tax. This is because the contributions were not taxed when they went into the annuity. By contrast, payments to your non-qualified annuity will only involve income tax limited to a portion of your payments. This is because the principal you have invested has already been taxed.
If you choose a non-qualified annuity and the payments factor in your life expectancy, then living beyond the age stipulated in the contract will result in changes to your taxes. For instance, if you start collecting payments at 65 and have a life expectancy of 85 but manage to live up to 97, then your payments from when you are 65 to 85 will be based on your exclusion rate, but your payments from when you are 86 to when you reach 97 will be subject to tax.
If you withdraw money from the policy before you reach a set age, you will shoulder a 10% penalty, CNBC warns. That early withdrawal penalty should be factored in before you decide to withdraw from the policy. You can transfer the money from one fund to another without paying taxes, but that condition only applies if you don’t withdraw the money.
You get taxed whenever you take money from the annuity or another pre-tax retirement plan. If you buy the annuity with pretax money, it will render the entire balance taxable. If you have after-tax funds, then only the earnings will be taxed. Cashing out a deferred annuity in a lump sum, you will end up paying for income taxes on earnings you get that are higher than your original investment.
Know your options
Contact us today or your CPA for questions and to get the complete picture of how taxes can affect your savings and how you can protect your nest egg with a policy from Peak American Financial.