Are All Fixed Annuities Tax Deferred?
Demystify fixed annuity taxation. Understand the inherent nature of their tax deferral and its varying implications throughout the investment lifecycle.
A fixed annuity is a contract between an individual and an insurance company that guarantees a fixed rate of interest for a specified period. Fixed annuities are generally tax-deferred, meaning earnings accumulate without being subject to annual income tax until a withdrawal occurs.
Understanding Tax Deferral in Fixed Annuities
Tax deferral means investment earnings grow without being taxed until withdrawal. During the accumulation phase, interest credited to the annuity is not subject to annual income tax, allowing earnings to compound over time.
The money invested in an annuity is referred to as the “principal.” For non-qualified annuities, this principal typically consists of after-tax money. The “earnings” represent the growth on this principal, including accrued interest.
Only these earnings are subject to taxation when money is eventually withdrawn. The original principal is not taxed again because it was already taxed before being put into the annuity. This deferral applies throughout the accumulation period, regardless of whether the annuity is part of a qualified retirement plan or is a non-qualified contract.
Taxation Rules for Fixed Annuity Withdrawals
When funds are withdrawn from a fixed annuity, specific tax rules apply. For non-qualified annuities, the “Last-In, First-Out” (LIFO) rule means earnings are considered to be withdrawn first and are taxed as ordinary income.
Once all the earnings have been withdrawn and taxed, any subsequent withdrawals of the original principal are not subject to further taxation. This is because the principal was initially invested with after-tax dollars.
A 10% additional tax generally applies to the taxable portion of withdrawals made before the annuity owner reaches age 59½. Exceptions exist for withdrawals made due to death or disability of the owner, or if the distribution is part of a series of substantially equal periodic payments (SEPPs) that meet IRS guidelines.
For annuities held within qualified retirement plans, such as IRAs or 401(k)s, all withdrawals are generally taxed as ordinary income. This is because contributions to these plans were typically made on a pre-tax basis or were tax-deductible, making both contributions and accumulated earnings subject to income tax upon withdrawal.
Impact of Annuity Type on Taxation
The tax treatment of a fixed annuity is influenced by whether it is a qualified or non-qualified contract. Non-qualified annuities are purchased with after-tax dollars; only accumulated earnings are subject to ordinary income tax upon withdrawal, as per the LIFO rule.
Qualified annuities are held within tax-advantaged retirement accounts like Individual Retirement Arrangements (IRAs) or 401(k) plans. Contributions to these accounts may have been made on a pre-tax basis or were tax-deductible. Consequently, all withdrawals from qualified annuities, including both contributions and earnings, are typically taxed as ordinary income.
A notable tax implication for qualified annuities is the requirement for Required Minimum Distributions (RMDs). These distributions mandate that the annuity owner begin withdrawing a certain amount from their account once they reach a specific age. For individuals born between 1951 and 1959, RMDs generally begin at age 73, while those born in 1960 or later will typically start RMDs at age 75. Failure to take RMDs can result in a significant excise tax, which can be 25% of the amount that should have been withdrawn.
Upon the death of the annuity owner, beneficiary taxation also differs based on the annuity type. For qualified annuities, beneficiaries generally pay income tax on the entire inherited amount. For non-qualified annuities, beneficiaries typically only pay income tax on the untaxed earnings, with the principal being tax-free.