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Posted by Jim McClaflin, EA, NTPI Fellow, CTRC

Understanding Tax Annuities: Which Has the Lowest Tax?

Understanding Tax Annuities: Which Has the Lowest Tax?

When considering annuities, it is essential to understand the tax implications. Many people, however, might be surprised because the taxation of pensions differs. This article explores the tax implications of annuities so you can make a reasonable decision.

When your annuity grows, you need not pay income taxes on them. This can wait until you withdraw the money or start receiving payments. Taking the funds out will be classified as income. Whatever you pay as tax is a factor of what you use to buy the annuity – post-tax or pre-tax money. 

Your withdrawal will be subjected to income taxes for an annuity that you got with pre-tax funds. Also, earnings you got with post-tax funds will be taxed. 

How Are Annuities Taxed?

The funds in your annuity will grow and only be subjected to tax once you start withdrawing. Many people consider this a benefit since the funds grow without annual taxes. When you, however, withdraw, the money will be subjected to income taxes. The implication is that the tax rate on such withdrawal will be similar to your tax rate on other income.


Annuities that are least Taxed

Roth IRA Annuity: Normally, after-tax dollars are used to fund Roth IRA. This makes all withdrawals tax-free, including principals and interest. This might affect the funds you have and your entire tax liability.

Non-Qualified Annuity: This annuity type is an investment account that helps you save for retirement while deferring taxes. It has no contribution limits as well. In other words, no tax payment on whatever fund you add to the annuity, but the annuity incurs charges. 

Long-term Care Annuity: You will not pay taxes on your income from a long-term annuity, provided you use the withdrawals for long-term care facilities and care that qualify. 

Retirement Annuity: How It Reduces Tax 

You don't fund non-qualified annuities with retirement plan dollars that qualify. When you start withdrawing, the earnings will be taxed. Also, there will be tax payments on the contributions. 

Does an Assigned Annuity Come with Tax Consequences?

While one can assign an annuity to someone else, there are tax penalties. Anyone with an assigned annuity who is not the owner will pay taxes on the annuity earnings. The primary owner will not pay taxes on such earnings.

However, the status of the annuity (qualified or non-qualified) will also determine the tax consequences. A qualified annuity, like an IRA, will not have the earnings taxed at the withdrawal point. An unqualified annuity, on the other hand, will have the earnings taxed when withdrawn. 

Spouse and Annuity Assignment: You can assign an annuity to your spouse without incurring any tax effect. Only spouses can enjoy these advantages but a child or any other dependent will trigger tax consequences.

What Happens When You Give Up An Annuity 

Surrendering an annuity will trigger tax debt for the policyholder on the tax earnings. Also, whatever contributions are deducted from the annuity will have tax debt.

Taxation of Inherited Annuity

This annuity type is usually passed to an heir when the owner dies. The new owner will pay tax on such annuity. Also, the tax consequence depends on the annuity type – qualified or unqualified. 

When it comes to taxing the death benefits of an annuity, the whole amount will be taxed at withdrawal if it is a qualified annuity, like an IRA. A non-qualified annuity, on the other hand, will only have the earnings taxed at withdrawal, not the whole annuity. 

For annuity owners who want to leave funds to their loved ones after death, life insurance is an option that is free from taxes. There might not be a need for medical exams in a few cases. 



Jim McClaflin, EA, NTPI Fellow, CTRC
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