If you're looking to supplement your retirement portfolio with an annuity, you'll want to know how annuities are treated when it comes time to pay taxes. Every financial product carries tax implications, but the rates at which they are taxed can vary greatly depending on the type of product and your taxable income.

Are annuities taxable, then? Short answer: Yes, but they fall into a special tax category. Let's break it down.

How Are Annuities Taxed?

The biggest advantage of annuities is that they're tax-deferred. Tax deferral is a special tax treatment that lets you delay paying taxes on a certain financial product like an annuity. It's sometimes explained as a triple-compounding benefit: You earn interest on your principal, interest on that interest (aka compound interest) and interest on the money that you would have lost to taxes.

Another key aspect of an annuity is the ability to complete a 1035 exchange. A 1035 exchange is a provision in the tax code that lets an annuity owner transfer funds from an annuity or a life insurance policy to another account of the same kind without incurring taxes. If you want the flexibility to change contracts over time, this feature might be beneficial.

So, with tax deferral, your annuity essentially grows tax-free until you withdraw funds from it. But deferred taxes are still taxes, and annuities are typically taxed at ordinary income tax rates and don't receive the favorable rates that stocks, bonds and mutual funds do. That is, unless you hold the annuity within a qualified retirement plan.

Annuities Held in Qualified Retirement Accounts

Qualified retirement plans include individual retirement accounts (IRAs), 401(k)s and other employer-sponsored plans. These accounts are vehicles for holding financial assets, such as stocks, bonds, mutual funds and, notably, annuities. When you hold an annuity in one of these accounts, you can receive certain tax advantages — for example, let's review the two main types of IRAs and their tax benefits.

Traditional IRAs are funded with pretax dollars, meaning you can receive a tax deduction on your contribution amounts ($6,000, or $7,000 if you're over 50, according to the IRS). Because the tax deduction comes when you make the contribution, all the money made in a traditional IRA is taxed at the usual income tax rates.

Roth IRAs, on the other hand, are funded with post-tax dollars, so you won't receive any tax breaks on the contributions. However, because your contributions to your Roth IRA have already been taxed, withdrawals from the account are tax-free once you hit 59 1/2 and you've had the account for five years. Returns from a Roth IRA are untaxed, too, and can be enjoyed for the remainder of your lifetime.

Is an Annuity Right for You?

Annuities offer several tax advantages, the most significant of which are tax deferral and, in the case of annuities held in qualified retirement accounts, the ability to control whether you pay taxes on the contributions or the withdrawals. When researching which type of annuity is right for you, take into account your financial goals and objectives and any qualified accounts you might be able to leverage before making a decision. Speaking with a financial advisor can help streamline the process and ensure that the annuity you purchase fits into your financial plans.