A tax-deferred annuity is a long-term investment product issued by insurance companies. You can generally choose from a variety of fixed and variable investments, such as CDs and long-term fixed-interest returns as well as investments tied to the performance of stocks and bonds. You pay no tax on your investment returns until you make withdrawals.
When Can I Make Withdrawals?
You can make withdrawals from a tax-deferred annuity at any time. However, keep in mind that the product is designed for long-term investing. Since you earn interest on interest, any early withdrawal can mitigate the advantages of deferring tax on that interest.
Are They Taxable?
All or a portion of your tax-deferred annuity withdrawals ia taxable at ordinary income rates, depending on whether the annuity is qualified or nonqualified. A qualified annuity is one you purchase through a pension plan at work. You fund it with pretax dollars, meaning the portion of your income you use to make contributions is not subject to income tax. A nonqualified annuity is one you purchase on your own directly from the insurance company. You fund it with after-tax dollars, meaning you already paid income tax on the money you put in. Every dollar you withdraw from a qualified annuity is taxable. When you withdraw from a nonqualified annuity, only the tax-deferred interest portion of your withdrawal is taxed.
What Are My Options?
You can make unscheduled cash withdrawals or take a series of payments called an immediate annuity. With an immediate annuity you have the option of taking a series of payments for a predetermined length of time, called a Term Certain Annuity. You can also receive a series of payments guaranteed for your entire lifetime, called a Life Annuity. Cash withdrawals help you maintain liquidity, but there's the risk of running out of money. Immediate annuities guarantee your income, and a life annuity ensures you will never run out of money as long as you stay alive. You give up liquidity, however, as your payments are locked in and cannot be changed.
Are There Any Withdrawal Fees?
Each tax-deferred annuity contract is different, depending on which insurance company you deal with. A tax-deferred annuity typically contains some form of withdrawal or surrender charge if you make an early withdrawal. The charge is typically a percentage of the withdrawal and phases out over time.
Are There Penalties for Withdrawal?
If you take money out before age 59½, the IRS charges you a penalty tax of 10 percent on top of any regular taxes you have to pay. The penalty tax applies to every dollar you take out from a qualified annuity, and to the interest portion you withdraw from a nonqualified annuity. You can avoid the penalty if you are disabled or if you take withdrawals in the form of an immediate annuity that pays for at least five years or to age 59½, whichever is longer.
- Annuity Advantage: Fixed Tax Deferred Annuities
- Edward Jones: Annuity Taxation
- IRS: Publication 939
- IRS: Publication 575
- Immediate Annuities: Early Withdrawal (Pre 59-½) Penalty Tax Exceptions and Annuities
- Free Annuity Rates: Fixed Annuity Disadvantages
- Immediate Annuities: Non-Qualified Annuity Tax Rules
Philippe Lanctot started writing for business trade publications in 1990. He has contributed copy for the "Canadian Insurance Journal" and has been the co-author of text for life insurance company marketing guides. He holds a Bachelor of Science in mathematics from the University of Montreal with a minor in English.