Retirement Advice on the Tax Advantages of an Annuity

Written by , April 5, 2012

Retirement Advice on the Tax Advantages of an AnnuityMany people have likely heard of annuities when they’ve done research about their retirement planning. But there’s a good chance that not everyone fully understands what annuities are and how they can play a significant role in an individual’s retirement planning.

In essence, an annuity is a financial contract between you and an insurance company. In exchange for a single payment or a pre-determined series of payments, the insurance company agrees to provide you with certain benefits once you reach retirement. There are some choices you must make regarding how you want your annuity to be paid out once you enter retirement. Whether an annuity is right for you depends on your particular financial situation, but it’s worth noting that annuities do have some tax benefits worth considering.

Here is some retirement information and advice on the tax advantages of an annuity.

  • Invested Amounts Grow on a Tax-Deferred Basis. Unlike retirement savings vehicles such as 401(k)s and traditional IRAs, deposits into an annuity are not tax deductible. Instead, the power of an annuity comes from the fact that all investment and interest income builds up within the annuity account on a tax-deferred basis. This means that the account holder won’t have to pay any taxes on any gains until they start withdrawing those funds.
  • Deposits are Not Taxed Upon Withdrawal. Because your contributions into an annuity are not tax-deductible, those dollars are not taxed again when you withdraw them from your account. This means that some of the payments you receive back from your annuity will not be taxed.
  • No Contribution Limits. Unlike 401(k)s and IRAs, there are no eligibility requirements or contribution limits for annuities. This means that even if you’ve maxed out your contributions on all of those other types of retirement accounts, you’re still free to invest as much as you like in annuities.
  • Different Payout Options. Most annuities allow you to choose what type of payout to receive when it comes time to access your savings. The basic options are to take a single lump-sum payment, or to take guaranteed periodic payments either for a specific period of time or for the rest of your life. By selecting a payment stream (either for a fixed period of time or your lifetime), you further delay paying taxes on your investment gains from the annuity.
  • Indirect Tax Advantages. Retirees who have an annuity as part of their retirement portfolio can strategically differ accessing their other retirement accounts. For example, a retiree may elect to take a lump sum payment or a short periodic payment schedule from their annuity so that they can continue letting their tax-advantaged accounts continue to grow (including accounts such as a Roth IRA, where eventual withdrawals will be completely tax free). By using an annuity in this way, a retiree can also delay taking Social Security until age 70 (and therefore maximize their Social Security benefits).
  • Annuities are not as common as IRAs and 401(k)s in most retirement strategies. While annuities don’t have quite the same tax advantage as those other types of accounts, they do have a place in some individual’s retirement portfolios.

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