How are annuities taxed?

Your Funding Source Matters

One of the most popular questions when it comes to annuities is, "How are they taxed?"

While all annuities grow tax-deferred, it depends on how you've funded your annuity.

Before we get started, keep in mind as with all tax-related questions, you should consult with your tax advisor first to determine your specific situation and implications.

Qualified vs. Non-Qualified Funding

Annuities can be funded with pre-tax (qualified) or post-tax (non-qualified) dollars, each with its own set of advantages and considerations.

Again, all annuities offer tax deferral, which means you don't pay taxes on the earnings until you withdraw them.

Qualified Annuities (Pre-Tax)

A qualified annuity is funded with pre-tax dollars, often through a direct rollover from a 401(k), 403(b), IRA, Roth IRA, or TSP. An old employer-sponsored plan, like a 401(k), is transferred into a new IRA set up by the insurance carrier when rolled into an annuity. A direct rollover is a non-taxable, penalty-free event.

This generally involves a phone call and submitting signed 1035 transfer paperwork to your 401(k) custodian. At Revise, we manage the entire process for you.

You can fund a non-qualified annuity by sending cash via ACH transfer or by liquidating a taxable account and transferring the proceeds to one of our A+ rated carriers.

The contribution thresholds for IRAs, which also apply to your annuity, are:

• Under Age 50: $7,000 annually.
• Age 50 and Older: $8,000 annually (includes a $1,000 catch-up contribution).
• Withdrawals are taxed as ordinary income.
• Early withdrawals (before age 59½) incur a 10% penalty plus income taxes, with exceptions like first-time home purchase, qualified education expenses, or substantial medical costs.
• Required Minimum Distributions (RMDs) start at age 72 (after age 73 starting in 2023 if you turn 72 on or after January 1, 2023).

Here's why this is a popular option:

Tax-Free Rollover: You can move funds directly from your 401(k) or IRA to an annuity without paying taxes immediately.

Lower Fees: Often, you can save on administrative costs compared to maintaining funds within a 401(k).

Hands-Free Management: Many annuities offer professional management, potentially yielding better returns than mutual funds within a 401(k).

However, one limitation is that you cannot actively manage the index tied to your annuity. Instead, you typically have the option to elect a new index only once per year.

Non-Qualified Annuities (Post-Tax)

Post-tax, or non-qualified annuities, are funded with after-tax dollars. There are fewer limitations or regulations here to consider. Keep in mind that early withdrawals may incur an IRS penalty.

Here's how they work:

• Fund: You can fund a non-qualified annuity by sending cash via ACH transfer or by liquidating a taxable account and transferring the proceeds to one of our top-rated carriers.
• Enjoy Tax-Deferred Growth: The primary benefit is that your investment gains accrue on a tax-deferred basis. This can be a significant advantage over similarly yielding fixed-income accounts and high-yield savings accounts, where gains are taxed annually.
• Taxed only on gains: Since you've already paid tax on your premium, income tax is due only on the gains from your annuity in the year of distribution.

Taking Early Withdrawals Using 72(q) and 72(t)

Planning for early retirement or needing access to your retirement funds before age 59 1/2 can be challenging due to the potential for IRS penalties. However, there are exceptions through IRS rules 72(q) and 72(t) that allow for penalty-free early withdrawals from annuities and IRAs, respectively.

72(q) - Non-Qualified Annuities

• Purpose: Rule 72(q) applies to non-qualified annuities, which are funded with post-tax dollars. It allows for early withdrawals without facing the usual 10% IRS penalty.
• Substantially Equal Periodic Payments (SEPP): To qualify for penalty-free withdrawals, you must take substantially equal periodic payments. This series of withdrawals must be carefully calculated and remain consistent. Your tax professional will be able to provide an estimate of these payments for you.
• Duration: The withdrawals must continue for the longer of five years or until you reach age 59 1/2. Making changes to the payment schedule before this period can result in penalties.

72(t) - IRAs

• Purpose: Rule 72(t) applies to IRAs and allows individuals to take early withdrawals without incurring a penalty.
• Substantially Equal Periodic Payments (SEPP): Similar to 72(q), you must commit to a series of substantially equal periodic payments. Your tax professional will be able to provide an estimate of these payments for you.
• Calculation Methods: There are three methods to calculate SEPP: Required Minimum Distribution method, Fixed Amortization method, and Fixed Annuitization method. Each method has different calculations and results in varying withdrawal amounts.
• Duration: As with 72(q), these payments must continue for five years or until age 59 1/2, whichever is longer.

Streamlined Process with Trusted Carriers

In either case, whether you're opting for a qualified or non-qualified annuity, your funds are sent directly to the carrier of your choice. We never act as an intermediary, ensuring a smooth and secure transfer. Our team is available for live phone support to assist you through the process, making it as hassle-free as possible.

By focusing on the unique advantages of both pre-tax and post-tax annuities, you can tailor a retirement strategy that aligns with your financial goals and minimizes your tax burden.