Tax-Deferred Annuity Taxation Rules

The IRS charges an extra 10-percent penalty on early annuity withdrawals.

The IRS charges an extra 10-percent penalty on early annuity withdrawals.

The tax-deferred annuity is a tax-advantaged plan that can help you save for retirement. While this account doesn't have as many benefits as regular retirement plans, it also has fewer restrictions. Before investing in a deferred annuity, you should clearly understand its tax rules, especially regarding withdrawals. If you don't plan your annuity correctly, you could get hit with a number of extra taxes and fees.

Investment Earnings

There are two main categories of deferred annuities: fixed and variable. Fixed annuities pay a guaranteed, fixed rate of return on your account. Variable annuities invest your money in the stock market, and your earnings depend on how your investments do. In both cases, the deferred annuity defers the taxes on your investment gains; you don't need to pay tax on your investment earnings until you start taking money out of the account. When you invest in a regular brokerage account, you owe taxes on your gains right away, even if you reinvest the money.

Contributions

The only tax advantage the annuity offers is that it delays taxes on your investment gains. You don't get a tax deduction for investing in a deferred annuity like you would with a 401(k) or an IRA. However, annuities don't have any contribution restrictions. You can invest as much as you want per year in an annuity. Retirement plans limit your annual investment. You can also invest in an annuity no matter how much money you make per year. If you make too much money, you are ineligible for some retirement plans.

Annuity Payments

When you are ready to start receiving income from your deferred annuity, you can annuitize it. This means you convert your account into a stream of payments for sometime in the future. You can choose a fixed number of payments or have the annuity make payments for the rest of your life. When you start receiving payments, they will be a mix of your contributions and investment gains. You get your contributions back tax-free but owe income tax on your investment gains.

Withdrawal

You can also cash out your annuity in a lump-sum withdrawal. You get all your money out at once and don't need to wait for payments each month. However, you could get charged extra taxes and fees. When you take a withdrawal, you'll owe tax on all your annuity gains right away. If you are younger than 59 1/2, you'll also owe an extra 10 percent penalty on your gains. Lastly, your annuity company could charge a surrender fee for ending your contract (this is likely if you end your contract within the first five to seven years).

 

About the Author

David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.

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