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Are Annuities Taxable?

Annuity can be instrumental in preparing for your retirement or securing payments for major life purchases like mortgages. Before you invest in annuity, you need to understand how annuities are taxed and how this can impact your financial status. In this article, we define annuity and discuss taxation of annuities so that you can decide how to invest in annuity or sell yours for the best financial results.

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What Is Annuity?

According to USNews.com, annuity is a series of equal payments, paid to a recipient at a consistent rate. For example, mortgage payments, insurance payments, pensions, or lottery earnings are all annuities. Further, there are different types of annuity:

Fixed Annuities

Fixed annuities are payments that an insurance company promises to pay a recipient at some time in the future, for instance in 10-20 years. A good example is a retirement plan. With a fixed annuity, there is no opportunity for funds to increase in value, however, there is no chance for it to decrease either, making it a safe option for recipients.

Variable Annuities

Variable annuities are payments that can increase or decrease in value depending on the success of the investments that a recipient chooses. Therefore, this type of annuity is a bit riskier, but it does provide the recipient with the potential to receive more money each month, should the investments do well.

Immediate Annuities

Immediate annuities are those that are paid to the recipient directly after they pay an insurance company a lump sum payment. This type of annuity guarantees recipients tax-deferred income each month for the rest of their life.

Deferred Annuities

Deferred annuities are those that a recipient sets up with an insurance company to accumulate savings over time. The deferred annuity will not be taxed until the recipient takes the money out for retirement or another purpose.

The type of annuity you have can have a significant impact on the level of taxation your payments receive.

How Are Annuities Taxed?

Annuities are taxed based on multiple factors regarding the source of funds, the account funds are stored in, and the time period in which a recipient withdraws those funds to receive income payments:

Qualified Annuity vs Non-qualified Annuity

The first way to determine how your annuities will be taxed is by identifying the source of funds and the type of account used to store them before they are withdrawn for income. This can be broken down into qualified annuities and non-qualified annuities.

Qualified annuity is when the funds used to pay for annuity have not yet been taxed. For this reason, any payments you receive will be taxed as income tax. Hence, “qualified” annuities can further be defined as funds that are qualified for taxation.

In contrast, non-qualified annuity is when the funds used to pay for annuity have already been taxed. This means that annuity recipients will only be taxed on whatever money they earn from their annuity payments, rather than their initial payment to purchase annuity. Therefore, “non-qualified” annuities can be further defined as funds that are not qualified for taxation.

The way the government taxes non-qualified annuity is determined by the exclusion ratio. This ratio helps determine how much your annuity is taxable by the government. The factors used to determine the amount of taxation include how the annuity was purchased, interest rates, and the timeline for the annuity.

For example, if you purchase annuity with money that was already taxed by the government, and you are expected to live for 20 years once you retire, then the government will only tax a percentage of your earnings. If you live past the 20-year life expectancy, the government will start taxing all of your earnings as income.

Annuity Withdrawal Taxation

If you withdraw funds from your annuity account before the start of your retirement, those funds are taxable by the government. You might also have to pay an additional fee as a penalty for taking out funds before your retirement age. Any other funds you withdraw from your annuity before retirement will be charged as income for that year.

By understanding how to handle your annuity, you can further understand how your choices early on will affect the future rate of taxation you receive from the government and how this can help or hurt your earnings.

Is There Such Thing as a Tax-free Annuity?

There is technically no such thing as a tax-free annuity, however, according to Kimberly Lankford, you can take financial measures to ensure that not all of your annuity gets taxed.

The first way is if you apply for an immediate annuity. In this situation, the amount of money you initially pay in a lump sum payment to the insurance company will be returned back to you, tax-free, over a period of time. However, all other income payments will be taxed.

The second way is if you transfer funds from one annuity account to another while it is deferred. This is called a 1035 exchange. For example, if you have want to transfer $5,000 from one deferred savings account to another, you will not be taxed on that amount because it is still deferred until the time you retire. To sum it up, it will not be taxed as long as you do not withdraw it from the accounts.

The third way you can avoid taxation on annuity involves the type of money you use to buy it in the first place. For example, if you choose to buy your annuity with pre-tax funds, meaning funds that have yet to be taxed, then everything will be taxable. In contrast, if you buy your annuity with after-tax funds, meaning funds that remain after taxes have been taken out, then you will only get taxed on your monthly payments, and the original sum you paid to receive the annuity, will be returned to you tax-free.

Therefore, although an annuity is not completely tax-free, there are measures you can take to lessen the amount of taxation that occurs, thus saving you some more money.

If you want to sell your annuity payment rights for an investment, contact a Paymaster representative today.

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