Annuities have special tax privileges that many investment vehicles don't have. Understanding how these taxes work can help you avoid unnecessary taxes on your retirement income.
An annuity is a retirement account investment vehicle issued by insurance companies. Many people use annuities to fund their pretax IRAs, but annuities can also be used on the after-tax side of the tax fence. Annuities are backed up by each state's guaranty association, which exists in case the insurance company that issued the annuity fails.
Annuities come in two forms: immediate and deferred. Immediate annuities are investment vehicles that provide a guaranteed payout for a certain period. Deferred annuities are investment vehicles in which the owner deposits either a lump sum or regular deposits. Deferred annuities can be "annuitized," which means the owner turns her deferred annuity into an immediate annuity.
Immediate annuities earn a specified rate of return internally determined by the insurance company, so the payout is a combination of an interest rate plus a return of principal. For deferred annuities, the owner chooses how to invest the money. Fixed deferred annuities offer a guaranteed interest rate every year based on company minimums. Index deferred annuities offer a chance to make a higher rate of return annually by having the asset mirror an index, such as the S&P 500. With variable deferred annuities, money grows based on investment divisions that mirror mutual funds.
Immediate annuity owners pay ordinary income taxes on some or all of their payout check from the insurance company. The amount depends on how much of his original investment had already been taxed. With a deferred annuity, the money grows on a tax-deferred basis. When money is withdrawn from the deferred annuity, ordinary income taxes are applied. How much of the withdrawal is subject to tax depends on how much of the original investment had already been taxed.
Consult a financial professional to learn how the different types of annuities work, and which one might be appropriate for you and your financial situation. An accountant or other tax professional should be consulted in order to address your tax concerns. Always read the complete policy details and understand each component before investing any money.