One of the primary reasons people buy annuities is the favorable tax treatment. However, even if annuity comes with tax benefits, it does not rule out the drawbacks. As a result, one needs to be aware of the tax benefits and disadvantages before deciding if the annuity is the best choice.
Without a doubt, tax information could be complex with many terms one needs to understand and subject to continuous changes. One can fund the annuity with an after-tax dollar or with another tax-advantaged plan like 401(k) or an IRA plan.
This article will center on the basic taxation rules for annuities that you fund with your after-tax dollars.
Premium taxation
The money paid into the annuity (premiums which are after-tax) is nondeductible. Directing funds into an annuity does not come with any immediate tax savings on your income, which might be present if one enrolls in a traditional 401(k), an IRA, or other retirement plan sponsored by the employer.
Tax-deferred growth
Any increase in your annuity value due to interest, unlike various investments, cannot be taxed. The funds in an annuity can grow tax-deferred till the time of distribution, at which the owner will have to pay the taxes (ordinary income tax) on the gains.
Premature Withdrawals: How is it taxed?
There is a 10% penalty from Uncle Sam on all withdrawals that are taken before the age of 59½. For every withdrawal from an annuity, Uncle Sam believes that the earnings will be withdrawn first. As a result, the 10% penalty is on the earnings. With this, judging from a tax standpoint, early withdrawals are costly.
For instance, for someone whose annuity has increased to $2,500, a $1250 withdrawal will be classified as a 100% interest, slammed with the 10% penalty, which is $125. Also, since the whole withdrawal stands for the earnings, there will be tax at the ordinary income tax rate. For someone in the 20% tax bracket, the income tax liability on the withdrawal will be $250. Summing this up with the penalty on early withdrawal, $375 of the $1250 you withdraw will be snatched by Uncle Sam.
How Scheduled Distribution are Taxed
The choice of any annuitization option will make one receive a regular distribution from the annuity plan stretched through a predetermined time frame. There are two components in each distribution:
Principal – the money you paid into your annuity
Earnings
The percentage of both earnings and principal for every distribution is a factor of the annuitization option you go with. For each distribution, the earning option will be considered ordinary income. Depending on the annuitization option as well, one might not be subjected to the 10% rule.
Important things to note: the guarantee of the annuity is a factor of the issuer's ability to pay the claim.
We classify variable annuity as long-term investments that make sense to fund retirement. As a result, they are subject to market fluctuations and the risk of investment, like loss of the principal. There are fees and charges in a variable annuity even though it is not limited to mortality and risk charges for the expense, charges for surrender and sales, administrative fees, charges for riders, and optional benefits.
The prospectus does sell variable annuities, which makes it essential for one to meticulously consider and explore the risk, charges, objectives, and expenses of the investment before making a choice.
Taxation of Lump-Sum Distributions
There are many effects and consequences of withdrawing a lump-sum distribution of one's annuity. One might even have to pay surrender charges if one decides in the first couple of years after buying the annuity.
The result is that the earnings of the distribution will be classified and treated as income in the same year that you take the distribution. Also, one needs to be aware that taking a lump-sum distribution could catapult one to a pretty high tax bracket that could come with substantial tax responsibilities.
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