An annuity, like a 401(k) or retirement account, provides you with an opportunity for tax-deferred growth. However, you cannot shield your investments from taxation forever. The federal tax code mandates required minimum distributions from many accounts, including annuities. Despite this rule, there are instances in which annuities are not subject to RMD requirements.
Insurance companies sell annuity contracts as life insurance contracts that provide living benefits. An annuity provides you with future income that protects you in the event you outlive your other income sources. If you purchase an immediate annuity, you begin to receive monthly income payments within a few months of the purchase date. With a deferred annuity, your premiums are invested in stocks and other instruments for a number of years before you can make periodic withdrawals.
Required Minimum Distributions
You typically pay tax on your income on an annual basis. However, you have the option of funneling some of your income directly into a so-called tax-qualified account such as an annuity or a retirement plan. You don't pay any upfront taxes when you invest your money this way. However, you must begin making periodic withdrawals from tax-qualified accounts beginning in the year you turn 70 1/2. The size of the withdrawals depends upon your life expectancy. All withdrawals are subject to ordinary income tax. You incur a penalty equal to 50 percent of the required withdrawal if you fail to withdraw the money.
Taxes on Withdrawals
Some company-sponsored annuity plans are funded entirely with pre-tax funds, in which case your taxes are based on the entire withdrawal. In other instances, you may have the option of contributing funds to an annuity plan on an after-tax basis. To avoid double taxation, you pay tax only on premiums and earnings that have not previously been taxed. Some annuity plans take the form of Roth individual retirement accounts. You don't pay income tax on withdrawals from Roths held in annuities or elsewhere as long as you're at least 59 1/2 and have owned the account for five years or longer.
Non-qualified annuities are exempt from RMD rules. The term "non-qualified" applies to any investments that you buy with already-taxed funds. Some investors buy fixed-rate non-qualified annuities as an alternative to regular savings accounts or certificates of deposit. Variable annuities containing mutual funds provide an alternative to investors who want to convert portfolios of stocks and bonds into an eventual income stream. As with a qualified annuity, a non-qualified annuity grows tax-deferred. You do have to pay income tax on your earnings, though not your principal. Furthermore, there are no rules stipulating when withdrawals must begin.
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