How Are Annuities Given Favorable Tax Treatment?

Article Summary:

Annuities are given “favorable” tax treatment because the IRS doesn’t require you to pay income taxes on funds within an annuity. You can choose between funding a qualified or unqualified annuity, which is funded with untaxed or pre-taxed funds, respectively. While you’ll still have to pay taxes on that money eventually, an annuity allows that money to gain interest first.

Unfortunately, getting out of paying income taxes is about as feasible as winning the Mega Millions jackpot. Lucky for you, however, we’ve got some tips to help mitigate the damage taxes can do to your retirement savings and put you on the path to incur massive income gains as you save for the distant future.

The answer lies in annuities. While an annuity cannot help you completely avoid paying taxes, it can minimize the havoc taxes can wreak on your ability to save money. Investing in an annuity fund will certainly get you favorable tax treatment, which will maximize your ability to live comfortably in your retirement, so long as you play by the rules.

If this all sounds intimidating and scary, don’t worry. What follows is a comprehensive guide to maximizing annuity payments and minimizing tax liability through the magic of annuity funds.

What is an annuity?

An annuity is an investment account you set up with an insurance company. You pay into an annuity (either in periodic installments or in a single, lump sum) with intention of receiving monthly annuity income payments at a certain point in the future.

There are too many different kinds of annuities to get into here. That being said, if you’re looking for more information and guidance on choosing the right type of annuity for your situation, you can read more here.

Pro Tip

There are a ton of companies that offer annuities. If you’re feeling overwhelmed, you may want to enlist the help of an investment advisor, who can advise you on how to best invest your retirement savings. Take a look at some of the investment advisors below to get started.

Annuities and tax deferral

What’s so exciting about the prospect of annuity funds is that the money you invest in one is not taxable immediately. So, while you’ll still have to pay regular income taxes, the money you invest in your annuity is safe from the sticky fingers of Uncle Sam.

This favorable tax treatment is a great loophole, even though you’ll still have to pay income taxes (sorry). What it means, however, is that the amount of money you’re able to invest (and therefore earn interest on) is not hampered by the federal income tax rate.

Annuity interest compounds just like any other investment. Therefore, the more money you have to earn interest on, the greater your interest earnings will be over the life of your annuity.

What’s more, when you defer income tax, you kick your tax liability down the road. The assumption is that those taxes will hurt less after your money pile has had a chance to grow unhindered by the income tax you need to pay on it.

It’s okay if you’re still a little confused. Here’s a little analogy to help make the point.

Think of it this way…

Imagine there are two puppies, Fluffy and Roy. They’re both the same size and should be eating the same amount of food as each other. However, Fluffy receives 3/4 of a cup of food every day whereas Roy is given a full cup.

After two years of this, they’re both grown into adult puppies, but Fluffy is much smaller and weaker than Roy. You realize you’ve made a terrible mistake and start giving Fluffy his quarter cup of food back every day, taking it from Roy instead.

The damage, however, has already been done. Fluffy will never be as big or strong as Roy, and Roy is already big and strong enough to handle getting a little less food every day at this point.

Fluffy represents your earned income if you don’t put it into an annuity. Roy is your income when you do put it into an annuity.

Sadly, income taxes cost Fluffy his health. Roy, on the other hand, enjoyed tax-deferred growth. He was fully grown before he started getting taxed, which ensured he was able to grow up bigger and stronger, just like you want your retirement savings to be.

Qualified vs. unqualified annuity taxation

Depending on how you fund your annuity account, it will be either qualified or unqualified. Whether your account is qualified or unqualified depends on when you pay income tax on the funds.

  • Qualified. Qualified annuity accounts have been funded with money that has not yet been taxed, as in that from an IRA. This means you’ll still pay taxes on the income you receive from these accounts once you begin receiving monthly disbursements.
  • Unqualified. Unqualified annuities, on the other hand, are funded with money on which taxes have already been paid. In these cases, you only have to pay taxes on the percentage of your income that is based on the growth of your annuity fund after you deposited the money. You may hear this referred to as the exclusion ratio.

If you happen to live longer than your life expectancy, any annuity payments made thereafter will be taxed fully, since the exclusion ratio is based partially on your life expectancy.

Deferral, not denial

Deferring taxes is a great way to allow your savings to grow, but it’s important to remember that you’re only deferring taxes, not avoiding them altogether. This goes for qualified annuity accounts, too. You’re going to pay taxes on your income; the difference is what you allow your money to do for you before you give it away.

If you allow your annuity to mature fully, once you begin receiving annuity payments they will be taxed just like any income. In most cases, your monthly annuity income payment is unlikely to be so large as to bump you up into a higher tax bracket.

Why you shouldn’t withdraw annuity money early

Early withdrawals from annuity accounts, while sometimes necessary, are not ideal in terms of maximizing the lifetime annuity earnings. There are a few reasons for this, but all of them involve the same thing: paying penalties or additional taxes to access your money before the annuity is mature.

Lump sum payment

Getting an initial lump sum payment may seem like a wonderful thing. And, of course, there may be situations in which you need one to survive. Unfortunately, in most cases doing so will increase your taxable income quite significantly. This means you’ll owe income tax as if you were a much wealthier person than you actually are (at least for that year).

Waiting until your annuity matures and you’re on a monthly payment schedule will allow you to keep your ordinary income tax rate and maximize the amount of money you earn over the lifetime of your annuity.

Related reading: Curious about the difference between annuitized annuity payments and a lump sum? Check out our article on the subject here.

Early withdrawal penalty tax

In most cases, if you cash out your annuity before you’re 59.5 years old, you will be subject to a 10% early withdrawal penalty tax. This is on top of the fact that you’ll pay taxes on the lump sum you received in a single fiscal year.


How do annuities save on taxes?

Technically, they don’t. You will still pay the same amount of taxes on your income, even with your money in an annuity. Deferred annuities, however, allow your money to earn interest before it’s taxed, so you make more money overall.

What method is used to determine the taxable portion of each annuity payment?

If your annuity was funded with money you had not paid taxes on yet, then the full amount of each annuity payment will be taxed.

However, if your annuity was funded with money on which you had already paid taxes, then only the portion of the monthly payment derived from the gains made on your annuity account over its lifetime will be taxed. The method of determining this proportion is called the exclusion ratio.

What is meant by favorable tax treatment?

This term refers to the “favor” the IRS does you by allowing your money to accrue interest in an annuity for as long as that annuity exists before they tax it. Then, because annuities tend to end in monthly disbursements as opposed to lump sum payments, you’re able to avoid moving into higher tax brackets.

Are annuity payments subject to a capital gains tax rate?

Fortunately, annuity payments are not subject to capital gains tax rates. This can be an even bigger incentive to start investing in one as soon as you’re able to.

Will cashing out my annuity put me in a higher tax bracket?

It depends on how you cash out and how much money is in your annuity. If you request a lump sum payment, it’s highly possible that you will end up in a higher tax bracket for that fiscal year. If, however, you take monthly disbursements, it’s highly possible you will stay in the same tax bracket you’ve always been in.

A way to check is to add up the total of all your monthly disbursements and add that to your income. If you aren’t sure what your monthly disbursements will be, you can call your financial institution (whoever holds your annuity) and they can tell you.

Key Takeaways

  • Annuities are given “favorable” tax treatment because the funds within the annuity are not taxed immediately.
  • You can fund an annuity with untaxed or pre-taxed money depending on whether you want a qualified or unqualified annuity.
  • Keep in mind that the money in an annuity is tax-deferred, meaning you’ll have to pay taxes on those funds eventually.
  • Even though a lump sum payment seems enticing, it’s best not to receive your annuity funds this way. Otherwise, you’ll likely end up in a higher tax bracket.
  • If you remove your annuity funds too early, you’ll have to pay an early withdrawal penalty tax.
View Article Sources
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