As you start planning for your financial future, you may start thinking about different methods for securing income after retirement such as an annuity. If you’re considering purchasing an annuity for retirement or already have an annuity that you want to understand better, it’s important to know your tax obligations. Here is the basic information you need to know about annuity taxes so that you won’t be surprised by tax requirements years down the line.
What Is an Annuity?
An annuity is a contract where you make a payment or series of payments to an insurance company and in return, they grow your investment and give you regular payments later on. There are two main types of annuities: fixed and variable. Fixed annuities have a pre-set interest rate that the insurance company agrees to pay based on how much you initially give them. With variable annuities, you select a variety of mutual funds to invest in, which could help you gain or lose money depending on how well those funds perform over time.
What Is the Purpose of an Annuity?
Annuities provide a form of income that you can rely on after you have retired. They can supplement other retirement plans to make sure that you will have enough money to live on, even if you outlive your retirement savings. Some annuities have a fixed payment period such as 10 or 20 years, but many annuities last for your entire lifespan. Depending on the terms of your agreement, an annuity can be a good way to improve your financial security.
How Are Annuities Taxed?
Annuities are tax-deferred, which means you won’t have to pay taxes on your annuity until your account has grown and you start receiving disbursements. If you have a qualified annuity, which is funded with untaxed funds like a 401(k) or Roth IRA, any payments you receive are fully taxable as income. You don’t have to pay traditional income taxes on non-qualified annuities that are funded by your income after taxes. However, you will have to pay taxes on the interest that your annuity earned over time.
There are many elements that factor into how individual annuity agreements are taxed, including how much you initially invest, how long you live compared to the terms of your annuity, and more. Checking with a qualified tax professional can help you develop a more accurate understanding of your specific tax responsibilities when it comes to your annuity.
How Can I Avoid Overpaying on Annuity Taxes?
Ultimately, the best way to avoid overpaying on your annuity is to let the funds mature until you are ready to retire. If you withdraw your annuity funds before retirement age, you will have to pay taxes immediately as income plus a possible fee for early withdrawal. You can also apply for an immediate annuity, where your initial lump-sum payment to the insurance company is returned to you tax-free before any other income. You can also move your money to another tax-deferred account.
By planning when and how you want to pay taxes on your annuity payments, you can stick to your financial goals and create an accurate long-term budget based on your needs.