Annuities and Taxes
Because people are living longer today, knowing that there will be enough income in retirement is a key concern. This is particularly true as a 20 or even 30-year retirement is becoming more common. Because annuities can guarantee an income for life, these financial vehicles are often used for securing incoming cash flow.
But depending on how your annuity is (or is not) taxed, there could be a big difference between the amount of your gross income amount and the amount that you have available to spend. With that in mind, it is essential to have a good understanding of annuities and taxation.
During the "Accumulation" Period
If you own a deferred annuity - which is an annuity that will not begin to pay out income until a time in the future - then the period of time before the annuity provides income is often referred to as the accumulation period.
During the accumulation period, the funds that are in the annuity account are allowed to grow on a tax-deferred basis. This means that, unlike a taxable investment, there will be no tax due on the growth. And this can provide the opportunity for the money to compound exponentially.
This is because your funds can earn interest on the principal in the account, as well as on the interest, and on the money that would have otherwise been taxed. Depending on how long your annuity is in the accumulation period, it's tax-deferred status can allow these funds to snowball significantly.
During the Income Payout Period
The way that income is taxed during the annuity's payout period will depend on whether you used before-tax money or after-tax money to fund the annuity. In this case, if you own an annuity in a personal bank or brokerage account, the funds that you deposit into it will typically be after-tax money.
In this case, the income that you receive from the annuity in the future will be partially taxable. For example, your income payments will essentially consist of two parts - one that is considered a return of your original contribution (and is thus non-taxable) and another portion that is considered to be gain (which is taxable at your ordinary income tax rate).
If, however, you fund the annuity with pre-tax dollars, the entire amount of your income payment would be taxable. This is because none of the funds inside of the annuity have yet been taxed.
Some examples of funding an annuity with pre-tax dollars would be if you "rolled over" money from your employer-sponsored 401(k) retirement plan, and/or if you funded an annuity that was inside of a traditional IRA (Individual Retirement Account).
How to Determine Your Net Income from an Annuity
Determining the amount of income that you will have available in your retirement years is a key component of your overall financial planning. So, it is important to be aware of how - and how much - your future income may be taxed. Discussing your options with an expert in the annuity field can help you to get a clearer picture of short- and long-term outcomes.