As we close in upon tax season, most folks are starting to wonder what they need to account for, which accounts are subject to taxes, and how their life insurance and annuities factor into the tax filing picture. We’ll take a quick look at annuities today and then, later this month, a more in depth look at life insurance. The more you understand about how taxes impact your financial plans, the better off you are from a strategy and financial standpoint.
Quick Links
- What are Annuities?
- Are Annuities Taxable?
- Understanding Annuity Taxation on Withdrawals and Payments
What are Annuities?
Annuities are, essentially, scheduled payments. When it comes to annuities contracted through an insurance company, clients typically pay either a lump sum or make several payments which are then redistributed to the client at a later date. Those payments are distributed based on pre-established increments based on the initial client deposit.
Are Annuities Taxable?
The simple answer is yes and no. Well, that’s not so simple, but thankfully the explanation isn't too complicated. First, annuities grow tax-deferred, which means there are no taxes until you make a withdrawal from the account. However, there are two kinds of annuities.
Qualified annuities are those that are funded with pre-tax money. Because no taxes have yet been paid on these funds, when it comes to qualified annuities, the entire amount, both the principal and earnings, is taxable.
Non-qualified annuities are funded with post-tax money and so only the earnings on the account are taxable.
In short, all annuities are taxable upon withdrawal, but the money used to create the annuity determines how much of the annuity is taxable.
Understanding Annuity Taxation on Withdrawals and Payments
In addition to understanding how annuities are taxed, and get the full picture, it’s important to understand a few other requirements regarding both qualified and non-qualified annuities.
For example, qualified annuities, because they have not yet been taxed, are subject to required mandatory distributions (RMD). More specifically, starting April 1st, the year you turn 72, you must begin taking RMDs unless the annuity is an employer plan and you are still employed, as an employee. This does not apply to business owners who sponsor their own annuities.
In contrast, non-qualified annuities function much like a ROTH IRA and do not require RMDs. However, both qualified and non-qualified annuities are subject to penalties or taxes for early withdrawals.
In fact, any annuity withdrawals made before you reach age 59½ may be subject to a 10% early withdrawal penalty tax. When it comes to qualified annuities, that means the entire withdrawal is subject to the penalty tax. For non-qualified annuities, only the earnings or interest are subject to the tax. On top of that, many carriers and providers also charge a penalty fee.
When you’re planning for your future, an annuity is a great option if you’re looking to supplement social security or other income streams and sources. Your money is allowed to grow, tax-deferred, and can then be distributed back to you when you need it most.
If you’re considering an annuity and wondering what options are not only available, but best for you, let the ELCO Mutual team connect you with an insurance agent who can offer you the expertise, advice, and products you need. Reach out today and let us help.