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How are annuities taxed?

How are annuities taxed?Annuities are taxed based on the method of payment and withdrawal. While stocks, bonds and certificates allow investors to build interest and dividends, an annuity allows the investor to receive future income in regular payout intervals.

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The majority of people who are planning for retirement are investing in an individual retirement account (IRA), or a 401K plan through their place of employment. Others are taking their financial plan to the next level by investing in securities and annuities.

What are the two types of annuities?

The two types of annuities are:

  • Immediate annuities – The investment is deposited with an insurance company and they immediately begin payout installments.
  • Deferred annuities– The investment is accumulated over time and the payouts begin after retirement or after age 59 and a half.

If the annuity is purchased with after tax dollars, such as from income, the money is taxed only at the time of withdrawal. The taxed portion is the money earned as interest or the accumulated amount. If the original investment is $5,000 and total interest earned is $2,500, the taxable amount is the $2,500. If the account is purchased with before tax dollars such as with monies transferred from an IRA or 401k the whole amount is taxed upon withdrawal as regular income.

The taxable amount is also based on life expectancy which is also how payouts are determined. If a person’s life expectancy is 30 years, and the annual payout is $10,000, then $3,333 is tax free and the rest is taxable at the regular tax rate.

What are variable annuities?

A variable annuity works like mutual funds in that the money invested is pooled with other investors. Different types of plans are offered to give the account holder more or less risk. These types of annuities are subject to more fees and expenses based on the type of plan option. Variable annuities are also more complex although they are in the position to earn the account holder a higher yield than a fixed annuity.

What is the difference between a fixed annuity and a variable annuity?

Monies earned and taxed on a fixed annuity are based on the contributions made by the account holder and the market itself, whereas the variable annuity earns money based on the stock market and how well the investment portfolio is doing. Just like anything that fluctuates, the variable annuity is riskier than the fixed annuity.

An additional factor of difference between the two is the level of regulation. Because of the complexity of the variable rate, they are more closely scrutinized by regulators.

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What is a 1035 Exchange?

Deferred annuities may be transferred or exchanged from one account to another without being subject to taxes by using a 1035 exchange. This is the case as long as no monies are withdrawn. If the funds are transferred from one insurance company to another before the initial penalty free period expires the account holder may incur a surrender fee.

Annuity Phases Simplified

The annuity goes through two phases which are the accumulation phase and the payout phase. During the accumulation phase contributions are made. The fixed annuity contribution is made to the account based on a fixed rate of interest, adjusted only by the insurance company with guaranteed minimums. A variable contribution may be distributed among several accounts based on percentages. The investor may own both types, and may request a percentage of the purchased payments to be distributed between each.

The payout phase takes place when the investor begins to receive payments which are intended to continue until death. If the purchaser of the account dies before the initiation of payments, they go to the designated beneficiary. The annual payments may be received monthly or annually. The account holder may also elect to receive a lump sum as well.

Payouts, Expenses and Fees

Payouts are subject to tax at the withdrawal phases. They may be paid out to a designee or the account owner. They are also established by the account holder with the guidance of an advisor or the insurance company. Account maintenance expenses apply to both the fixed and variable account; however, the variable account is subject to more for obvious reasons.

Fees are incurred for early surrender, mortality and expense as well as management of the account. These fees can accumulate and wipe out the tax advantage. This is especially true for the short term investor.

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