Is an Annuity a Good Investment? Tax Advantages and Disadvantages to Know

If you read the title of this article and are unsure how an annuity works, let alone how it impacts your taxes, you’re in good company. While they’re a potentially valuable retirement tool, data shows that annuities remain a mystery to many, including those approaching retirement age.

The American College of Financial Services recently find that annuities were the least understood retirement product among adults ages 50 to 75. This is despite the fact that nearly half of working adults in this age group are concerned about running out of money in retirement, according to the Life Insurance Marketing and Research Association (LIMRA).

At the same time, while annuities aren’t right for everyone, they can provide a steady source of retirement income that some experts say shouldn’t be overlooked. But like other financial investment products, annuities have potential tax advantages and disadvantages.

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Let’s break down some of the pros and cons.

What is an annuity?

Before we get into the topic of taxes, it’s helpful to know some basics. An annuity is a financial arrangement that converts your savings into a steady stream of income during retirement.

An annuity is a contract with an insurance company where you pay them money in the form of a lump sum or regular premiums. In exchange, the company agrees to make payments to you that may last for a set period of time or for your entire life. It is important to note that an annuity is not life insurance or a savings certificate.

Annuities can be immediate or deferred and come in different types with distinct features and risks. Different interest rates and sometimes complex administrative fees and other charges are also involved.

Tax Benefits of Annuities

The taxation of annuity payments generally depends on whether the money used to fund the annuity is pre-tax or after-tax, but annuities offer some tax advantages.

Keep in mind that these are general potential benefits of annuities. Whether an annuity is a good investment for you will often depend on your financial situation.

Tax-deferred growth. Your investment income grows tax-free. Contributions to non-qualified annuities are not deductible, but you don’t pay taxes on the earnings until you withdraw the money. As a result, the amount can compound over time.

Lower federal income tax bracket. You may be in a lower federal income tax bracket when you begin taking annuity distributions. So you may pay less tax on the distributions.

Payment flexibility. Annuities offer a variety of payout options, allowing you to structure your withdrawals to suit your financial situation. This can help you manage your taxable income, potentially reducing your tax burden.

Disadvantages of the annuity tax

Keep in mind that these are potential drawbacks of annuities, in general. Whether an annuity is a good investment for you will often depend on your financial situation.

One of the major tax challenges associated with annuities concerns tax rates. When you withdraw money from an annuity, the earnings are taxed as ordinary income, so you may pay more taxes than with other types of investments that benefit from lower capital gains tax rates.

Then you have to factor in early withdrawal penalties. If you withdraw funds from your annuity or cancel it before age 59 1/2, you will likely face a 10% early withdrawal penalty and ordinary income tax. There are some exceptions to potentially avoid the tax penalty.

Complex tax rules. The tax rules can be difficult to understand, especially when it comes to distinguishing between qualified and nonqualified annuities.

Qualified annuities are funded with pre-tax money, giving you a tax advantage now but requiring you to pay taxes on later withdrawals.
Nonqualified annuities use after-tax dollars, so you don’t get an immediate tax benefit, but you do owe taxes on the earnings when you withdraw them.

Qualified annuities, which are often part of retirement plans like 401(k)s and 403(b), are subject to IRS-imposed contribution limits, while nonqualified annuities are not. Additionally, with a nonqualified annuity, any 10% early withdrawal penalty would apply only to earnings, not principal.

Nonqualified annuities also don’t require you to take required minimum distributions (RMDs). However, the IRS does require owners of most qualified annuities to take distributions, typically starting at age 73.

QLAC?

If you’re concerned about required distributions, there’s a type of annuity called a qualified longevity annuity contract (QLAC) that you buy by transferring funds from your qualified retirement plan account. A longevity contract essentially allows you to set aside a portion of your retirement savings and deal with the IRS tax implications later.

For 2024, you can use up to $200,000 (lifetime limit subject to inflation adjustment) from your 401(k), traditional IRA or other eligible retirement savings account to purchase a longevity contract. If you are married, you can both use your respective accounts to purchase QLACs separately.

A longevity contract allows you to defer certain mandatory distributions until you turn 85. But remember, you’re deferring taxes, not avoiding them. QLAC payments are taxed as ordinary income.

Annuities: the balance sheet

The different rules, fees and features of annuities can be confusing. However, you need to navigate them effectively to avoid unexpected tax liabilities.

As always, it is a good idea to consult with a trusted and qualified financial or tax planner to help you assess the tax implications and decide if an annuity fits your retirement strategy.

Note: This article first appeared in Kiplinger Retirement Report, our popular monthly periodical that covers the top concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement tips This is absolutely correct.