Annuities share some tax characteristics with other types of retirement plans such as 401(k)s and IRAs, but annuities take the tax advantages even further than other retirement plan types. Please note that if the annuity is inside a retirement account then, the tax-advantages does not apply.
For the purposes of this discussion, we refer to non-qualified annuities, which are funded with money that has already been taxed.
The main tax benefit of annuities is the tax deferral of earnings. Unlike a regular brokerage account, bank account, cd or other types of taxable accounts, you are not liable for taxes on annuity earnings until they are withdrawn. The ability to keep your money invested without having to withdraw for taxes means that the power of compounding interest grows your money faster than it otherwise would.
Tax deferral is extremely valuable for those who predict that they will be in a lower tax bracket in retirement than they currently are. The ability to defer taxes until retirement can save these types of people a lot of money on taxes.
Unlike 401(k)s and IRAs, annuities have no contribution limits aside from those imposed by the insurance carrier. Carrier-imposed limits are very high – sometimes in the millions – so an annuity can be an effective vehicle for shielding substantial sums of money from taxation.
Another major benefit of annuities is that they have no required minimum distributions (RMDs). If you own an IRA, you must begin taking distributions once you reach age 70 ½, whether you like it or not. The fact that annuities are not subject to this requirement is beneficial for those who prefer to save their money for use much later in life.
Once your annuity contract reaches maturity, it is annuitized, meaning it is converted into a stream of income payments. These payments can be structured to last for a certain number of years, or even for the rest of your life. Thanks to a factor called the exclusion ratio, the tax consequences of these payments are very predictable. There are several ways to avoid annuitizing an annuity. Some annuities can have an income rider attached, you can exchange one annuity for another (this should only be done if there is a significant benefit to do so). These are the most common options.
The exclusion ratio is a percentage of each annuity payment that has will be exempt from future income tax. This ratio represents a return of your principal, which has already been taxed.
For example, if your monthly annuity payment is $500 and your exclusion ratio is 60%, you’ll know that you’re only responsible for the taxes on $200 per month. This can take some serious stress out of tax planning.