How to Avoid Paying Taxes on Annuities Taxes can be a major burden for retirees and people saving for retirement, so choosing the right investment vehicle is essential. However, once you retire, one of the most important...

Taxes can be a major burden for retirees and people saving for retirement, so choosing the right investment vehicle is essential. However, once you retire, one of the most important things to consider is how you will receive your income. Many people choose to annuitize their retirement savings, which can be a great way to let their savings grow tax-deferred and guarantee a steady income stream during retirement. However, there are a few things you need to know about annuities and taxes before making your decision. This post will explain how annuities are taxed and offer some tips on avoiding paying too much in taxes. Read on to learn more.

How does the IRS tax annuities?

You may have heard that annuities offer tax advantages, but what exactly does that mean? Does it mean that you won't pay taxes on the money you put in an annuity? The answer is no; it doesn't. You may be surprised to learn that annuities, 401(k)s and even government pensions are taxed on the year we start receiving them.

In general terms, the IRS sees annuities as investment vehicles for retirement, giving you the benefit of deferring taxes on your income until you retire. In other words, you won't pay taxes for the income used to pay your premium now, but later, when you start making withdrawals or receiving your annuity income.

However, it's important to note that not all annuities are the same. There are different types of annuities based on the particular terms and conditions of the contract, to begin with. These include immediate or deferred annuities, and fixed, variable or indexed annuities, among others. The IRS looks at these contracts to determine when and how you can and will receive distributions, how your money grows over time, and how long you can expect to receive payments.

Additionally, another very important piece of the puzzle is determining what portion of that income is taxable, and this depends on how you paid for your annuity, regardless of contract terms and conditions.

Qualified vs. Non-qualified annuities

Based on where the money to pay for an annuity came from, the IRS classifies annuities as qualified and non-qualified annuities.

In a qualified annuity, the premium is paid with pre-tax dollars, meaning it's paid with money that hasn't been taxed yet (something called pre-tax dollars), such as money in a 401(k), a traditional IRA or a 403(b) account.

On the other hand, you may pay your annuity's premium with money from a non-retirement account such as a savings account or similar. Since funds in those accounts don't count as retirement savings, you'll have to pay taxes on them every year. This implies that you would be paying for an annuity with post-tax dollars, which the IRS classifies as a non-qualified annuity.

How qualified annuities are taxed

Taxation on qualified annuities is straightforward. Since you haven't paid taxes on the money you used to purchase the annuity, you owe taxes on your principal, and you'll have to start paying those taxes the moment you start receiving distributions. Additionally, since your money will grow over time through interest, dividends, or capital gains, you'll also have to pay taxes on those earnings.

Since annuity income payments or distributions are made up of principal plus earnings, you pay taxes on the entire income or withdrawal you make from a qualified annuity every year.

How non-qualified annuities are taxed

In the case of non-qualified annuities, since you already paid taxes on the money used to pay for the annuity (your principal), you don't owe the IRS any taxes for that amount. However, you do still owe taxes on your earnings. This means that when you start receiving annuity income after retiring, you will still have to pay some taxes on your income, just not on all of it like you would in the case of qualified annuities.

In other words, only a portion of the income or withdrawals from a non-qualified annuity is taxed, and a portion is tax-free. That tax-free portion is calculated based on your exclusion ratio, which is determined by dividing your total investment in the annuity (your principal) by the total expected return.

Can you completely avoid paying taxes on an annuity?

As you can see from the above explanation, there is no way to avoid paying taxes on an annuity completely. Even if you take a non-qualified annuity (in which case you will already have paid taxes on your principal), you'll still have to pay taxes on any earnings you make through interest, dividends, or capital gains.

Furthermore, even though annuities are great to help your money grow faster through tax-deferral, one major drawback of annuity taxation is that all distributions, withdrawals or income from an annuity are taxed as regular income. This means that your earnings won't be taxed at the more favorable capital gains tax rate as they would in other forms of investment.

That said, you can optimize your annuity contract for tax efficiency by spreading your tax burden for many years. This, in combination with the purchase of a non-qualified annuity, can allow you to maximize your annual income while minimizing your taxable income without jumping into another tax bracket.

This involves more complicated calculations, and there are many other factors to consider, so it's always a good idea to consult an annuity specialist before deciding on which to buy.

Transferring an annuity to reduce taxes

One potential way to get the tax burden of an annuity off your shoulders is to pass the burden down to someone else by transferring your annuity. There are some situations when doing this makes sense, like when you want to pass the money down to a family member or heir or when you feel that the conditions of the current annuity don't work for you anymore and it seems better to get rid of it.

Withdrawing and repurchasing an annuity

One way to accomplish the above is to cash out on your annuity and then use the money to purchase a new one for yourself or someone else. However, this is probably the worst decision for several reasons. In the case of qualified annuities:

• If you're under 59 and 1/2, you'll have to pay an early withdrawal penalty fee of 10% to the IRS on the full amount.
• Regardless of your age, if you purchased your annuity recently, some insurance companies will charge you a surrender fee that can be as high as 8 or 10%.
• You'll have to pay taxes on the entire taxable income from your withdrawal that year, which can shoot you straight into another tax bracket.

Qualified transfers from custodian to custodian

A better option is to use a qualified transfer in which the insurance company transfers your annuity to someone else without ever giving your the money. This makes money stay tax-sheltered, so you won't pay the early withdrawal fee (because you're not withdrawing anything), although some income tax rules on qualified annuity transfers may apply.

People who do this are usually looking for a way to reduce their estate to reduce the estate tax they have to pay. However, things aren't as simple as they seem. If you transfer the annuity to someone as a gift, only the first $14,000 of its value will be tax-free. You'll have to pay estate taxes on the remaining portion of the annuity's value, following the federal gift tax law's rules.

Non-qualified annuity transfers

With a non-qualified annuity, the rules are different. You can cash out and pay the taxes on your earnings without paying any early withdrawal penalties.

You can also opt to transfer a non-qualified annuity to someone else. This process tends to be much simpler than in the case of qualified annuities, but transfers are also subject to the same gift tax laws mentioned above.

How to avoid paying taxes on an inherited annuity

When you purchase an annuity for yourself or someone else, you have the freedom to shop around and choose the insurance company and the particular contract terms and conditions that best suit your needs. You can also decide whether to go for a qualified or a non-qualified annuity to minimize the amount you'll have to pay in taxes every year.

But what happens when you inherit an annuity? What can you do to minimize your tax burden and avoid turning a windfall into a tax nightmare?

In this case, you don't have any control over the deceased annuitant's contract conditions. But, you can decide how to receive payments from the inherited annuity. You can choose between four options:

• A lump-sum payment
• Spread payments across five years
• Annuitizing your payments
• Opting for a non-qualified stretch

The first option is the worst in terms of taxation because you receive the full taxable amount, which adds a significant burden the year you inherit the annuity. Likely, the higher tax bill will also send you into a higher tax bracket, making this a bad choice unless you desperately need the money right away.

The five-year rule lets you spread the burden somewhat, but the taxable portion of the inherited annuity is paid out first, which could leave you in the same position as before. Therefore two best options for tax efficiency are annuitizing and choosing a non-qualified stretch.

Annuitizing the inherited annuity

In this case, you choose to turn the annuity into a stream of income for a fixed number of years or the rest of your life, and you'll be taxed based on the same general rules pointed out before. You can spread payments across several years, reducing the income tax burden every year.

The only downside to choosing this option is that it's non-revocable, so you won't have access to your full amount if you ever need it.

Spreading taxes over time through a non-qualified stretch

If you inherit a non-qualified annuity, you can choose a non-qualified stretch, which is similar to an annuitization, but you choose to stretch the annuity payments for the remainder of your life. If you choose this option, you'll have to take the required minimum distributions from the annuity every year and pay income tax on those withdrawals, but you can leave the rest invested and growing tax-deferred.

Offsetting taxes on an inherited annuity through an enhanced death benefit

If you want to leave a tax-free legacy to your heirs, there is a way to do it (or something similar to it). Some insurance companies offer special contract riders with an enhanced death benefit. The "enhanced" part of the benefit comes in as a bonus your heirs will receive upon inheriting the remaining balance in your annuity. This bonus can be as high as 30% or more of the inherited amount in some cases.

Your heirs will still have to pay taxes on the inherited annuity (as well as on the bonus), but the bonus is usually more than enough to offset the tax burden. This means they'll have the full amount (or even more) available even if they decide to cash out immediately. If they don't and go for one of the previously mentioned methods to extend the payout, they can stretch the money even further.

So, while it's not technically avoiding taxes, the end result is the same.

The 1035 exchange rule

Some of the ways to reduce taxes on annuities mentioned above require you to transfer or exchange an annuity contract to someone else or swap one annuity contract for another where you're also the owner of the contract.

In any of those cases, Section 1035 of the Internal Revenue Code has a rule that allows you to swap one annuity contract for another without paying income tax. In other words, it treats the transaction or swap as an internal process where you never receive any money from the insurer and are therefore not taxed.

If you plan to swap annuity products for whatever reason and want to minimize your tax impact, you want to make sure that the transaction falls within the available options of rule 1035. Otherwise, you'll have to pay taxes.

The bottom line for Annuities

Annuities can be a great way to save for retirement and receive tax-deferred growth, but when it comes time to take distributions or income, you'll likely have to pay taxes on that money. There are ways to reduce the amount of taxes you have to pay, such as annuitizing, choosing a non-qualified stretch or taking advantage of an enhanced death benefit. You can also exchange one annuity contract for another without paying income tax under Section 1035 of the Internal Revenue Code. However, none of these strategies are perfect or allow you to bypass your responsibility as a taxpayer, so the most you can hope for is to optimize your annuity to maximize income while minimizing income tax. This is not a simple task, but it's something a tax consultant can give you a hand with, putting you well on your way to relaxed and laid-back retirement.

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