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What are the tax benefits of annuities?

What are the tax benefits of annuities?Annuities are investment vehicles that allow investors to put away a sum of money in return for a guaranteed higher payout in the future. Most annuities are offered by insurance companies and funded through contributions from the investor’s salary.

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Sometimes the funding of an annuity is a one-time lump sum. Regardless, the tax deferment on the money being contributed makes it an attractive retirement investment.

Pre-Tax Contributions

In the case of most annuities, contributions are made through a pre-tax payroll deduction. That means several things for the investor. First, the money contributed to theĀ fund will not be subject to annuity income taxes until it’s withdrawn at a later date.

At first, the benefit might not seem apparent when you realize that tax must be paid on the money one way or the other. However, if you look at it in terms of taxable income, the benefit becomes clear.

Contributing to an annuity reduces taxable income for the year it was contributed. On the other end of the investment, when withdrawals begin, the investor’s taxable income will be lower because he no longer has a job.

In the end, he is basically splitting the income between present and future, reducing his taxable income on both ends. He will still pay tax on the interest earned, but at an average payback of 8%-12%, most people will still end up paying less tax through an annuity.

Lump Sum Contribution

There are times when an investor will make a one-time lump sun contribution to an annuity. In this case the money has most likely already been subject to normal taxation. It can be invested freely in an annuity with the knowledge that it cannot be taxed again upon withdrawal. Earnings are still taxed when withdrawals are made, and in fact, any withdrawals are first counted against earnings.

Tax-Deferred Earnings

Perhaps the greatest tax advantage of an annuity is the fact that the interest you earn on an annual basis is also tax-deferred. Again, the benefit is not so obvious unless you take into consideration the idea of compounding interest. In other words, as you earn interest on an annuity account, it gets added to the total account value every year which, in turn, earns you more interest.

Even though you’ll be paying tax on the interest later on, the compounding effect helps you earn more. Without tax-deferred earnings, federal and sate taxes, combined with the normal inflationary process would eat up most of your earnings every year. By making those earnings tax-deferred, you can employ compounding interest to make more money.

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Calculation of Taxes

Knowing that earnings are taxed before principle, how does the government figure your tax if you still have multiple years of payouts to receive? They use a table which calculates the average life expectancy of both men and women. They refer to the table when annuity payouts begin and calculate the total return on the investment.

For example, let’s say the average life expectancy of a 70-year old male with no serious health issues is 85. At the time he begins his payouts he will have 15 years remaining. The total number of payouts he is expected to receive, minus the principle he paid in, will be his earnings. All of the withdrawals he makes will be subject to both income taxes and capital gains, until he has taken enough out to cover his projected earnings.

One Potential Pitfall

Despite the tax-friendly nature of the annuity, there is one potentially costly pitfall: premature death. To help understand this, we’ll use the same 70-year old male as an example. Let’s just say he began receiving his payouts at age 70, and died unexpectedly at age 73. His widow or estate is still entitled to the remainder of the money in his annuity contract, but the taxes will have skyrocketed (in many cases, there is no beneficiary for an annuity, and the money goes to the insurer or issuing entity).

If his payments had not yet reached the level of estimated earnings, the government will compute that first, and asses the capital gains tax. Next, the entire remaining value of the annuity will be subject to the estate tax, otherwise known as the death tax. Finally, any real cash that winds up going to the widow or any family members will be taxed as income.

As with any investment, there are always risks involved. An annuity is a relatively safe investment form both the tax and personal risk perspectives. But, an untimely death could make your annuity a nightmare if you have beneficiaries involved. Invest wisely.

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