What Is a Tax-Deferred Annuity?

What Is a Tax-Deferred Annuity?

Whether you're getting an early start on planning for your retirement or you're jumping in later in life, it's completely normal to experience some uncertainty as you prepare your finances for your retirement years.

If you have some money saved but are still concerned about outliving your retirement savings, a tax-deferred annuity may be able to help. What is a tax-deferred annuity? It's a financial tool that acts as a type of insurance contract and guarantees you an income for life.

To help you better understand tax-deferred annuities, let's discuss the different types, their common characteristics and their pros and cons to help you determine whether a tax-deferred annuity would be a good fit for your needs.

What Is a Tax-Deferred Annuity?

A tax-deferred annuity is a financial tool that allows you to make contributions to a variety of underlying investments without paying taxes on those contributions until a withdrawal is made at a later date. Depending on the policy, you can typically decide how you want to allocate your payments among the investment options included in the annuity fund.

When you purchase this kind of annuity, you agree to fund the investment either upfront as a lump sum of money or through regular payments made over time. These types of annuities are designed with three aims in mind:

  1. Assisting you with saving money for retirement.
  2. Protecting what you've saved.
  3. Providing a tax-efficient, reliable source of income during the payout period.

What Types of Annuities Are Available?

The money you contribute to a tax-deferred annuity can grow through three primary annuity types: fixed, indexed and variable. These are all types of insurance contracts that pay different levels of income depending on your needs.

Fixed annuities promise to pay you a specific, guaranteed interest rate on contributions, while indexed annuities pay you interest based on the performance of a specific market index tracked by your annuity. With variable annuities, the value varies based on the performance of an underlying portfolio of mutual funds. As a result, you may see higher returns with a variable annuity than with fixed or indexed annuities, but this option also comes with greater risk.

Are Annuities Taxable?

By default, annuities are tax-deferred investment products. However, that doesn't mean you can avoid paying taxes on them completely.

Withdrawals and lump-sum distributions from annuities are taxed as ordinary income and not as capital gains, which are the profits resulting from the sale of an asset. As such, the amount of taxes you pay depends on how you contributed to the annuity in the first place.

When you contribute to an annuity with pretax dollars, payments you receive from the annuity are fully taxable as income. When you contribute with post-tax dollars, you only pay taxes on the earnings and must determine your appropriate exclusion ratio (the percentage of your return that is not subject to taxes) for tax planning. Work with your accountant or a financial professional to determine your exclusion ratio based on your specific circumstances.

Tax-Deferred Annuity Pros and Cons

If you have a high income, these retirement products can defer taxes during your prime earning years. You can also choose from a variety of options offering different levels of risk without taxes coming due until you receive payment. However, keep in mind that tax-deferred annuities can come with high fees, depending on the type of annuity you select. Additionally, investment gains are taxed as ordinary income, and these annuities sometimes have limited investment options.

Tax-deferred annuities can help you save for retirement, protect your savings and guarantee that you'll have a degree of income during retirement. If you're able to make regular contributions or fund an annuity with a lump sum, this option could help you arrive at a more secure and fulfilling retirement.

Riley Adams, CPA AuthorThumbnail

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