Consider the Favorable Tax Treatment of Annuities for Your Retirement

Throughout your career, you save money that you hope to live on when you retire. The most common retirement savings plans are employer-sponsored 401(k) accounts and IRAs. There's a third retirement strategy that often gets overlooked, and that’s annuities. Annuities are given favorable tax treatment, which makes them a good long-term investment strategy.

So, why are annuities given favorable tax treatment and are they a good investment strategy for you? Keep reading to find out.

An annuity is a financial product that can provide you with a guaranteed monthly income in your retirement days. Like 401(k) and IRA accounts, there are several tax benefits to investing in annuities. But, there aren't any caps on how much you can invest in annuities yearly, like there are with 401(k) and IRA accounts.

An annuity is also an attractive investment tool for retirement because it offers “longevity insurance,” so you don’t have to worry as much about outliving your retirement savings. You can choose to receive monthly payments from your annuity throughout your lifetime.

Annuities are taxed in two different ways. You can put part of your pre-tax income into an annuity, similar to a traditional IRA or 401(k). This is considered a “qualified annuity.” With a qualified annuity, you don’t have to pay taxes on the income until you take distributions, so your wealth can grow over the years tax-free. You shouldn’t take disbursements from a qualified annuity before age 59.5, otherwise you’ll have to pay a 10 percent penalty as well as the deferred taxes on the income.

An annuity that you’ve already paid taxes on is called an “unqualified annuity.” Much like a Roth IRA, the benefit of an unqualified annuity is that the government doesn’t tax the principal of your disbursements because you have already paid the taxes. However, you will have to pay taxes on capital gains or interest earnings on an unqualified annuity.

Which annuity is better for you, qualified or unqualified, depends on your individual circumstances and your goal for the annuity. For example, if you are investing in an annuity to help lower your taxable income, then a qualified annuity may be the way to go.

Investing in an unqualified annuity may be a better option if you want more accessibility to your funds. With an unqualified annuity, there isn't an age requirement for when you can start taking payouts. The IRS uses an “exclusion ratio” calculation to determine how much of your disbursement is tax-free and what's taxable.

A benefit to qualified annuities is that it enables you to invest more and thus grow your wealth because you don’t have to pay taxes on the income. Investing in a qualified annuity can also decrease your taxable income, putting you in a lower tax bracket, so you’ll owe less income taxes overall.

For unqualified annuities, the exclusion ratio used to calculate taxes on your annuity earnings provides a more favorable tax rate. The ratio considers the principal of the annuity, its length, and earnings. If you choose to receive annuity payments for life, your life expectancy will also be considered. The remaining annuity payments will be taxed as income if you live longer than expected.