Of the many questions we receive regarding retirement and investments, there is one category that elicits the most confusion. That category can be summed up in one word: annuities.

Annuities are one of the most misunderstood investment vehicles out there. Investors often don’t know what they are or why they have one. Brokers, agents, and advisors offer them with little to no explanation. There are multi-million dollar marketing campaigns for and against them. So, what’s a person to do?

The best thing to do is to educate yourself. As Ralph often says, “What you’re not up on, you’re down on.” So let’s get going.

Big Picture

An annuity is a category under the umbrella of investment vehicles where you can place your money. They can be held as a taxable (more on this in a bit), tax-deferred, or tax-free account.

Annuities are offered in various forms by many insurance companies and can help address longevity risk through guaranteed lifetime income.

They can be offered as a single premium deposit. This simply means that you cannot add more money to the account once it is opened. They can also be offered as a flexible premium deposit, meaning you can make additional deposits or contributions over part or the entirety of the life of the account.

Annuities can be offered as an immediate annuity, which means you get income now. They can also be offered as a deferred annuity. In other words, you defer income to some point in the future, if at all.

Graphics are often helpful. The picture below from the creative people over at Napkin Finance is a nice and simplistic overview of annuities. Keep in mind the word simplistic.

Consider this “Part One” in an ongoing series on annuities. We’ll take our time walking through a few important aspects in the weeks and months ahead, but for now, let’s look at the reasons someone would consider an annuity from a tax standpoint, as well as other tax considerations.

It is important to note here that any specific tax advice or recommendations regarding how you should handle a current or future annuity should be directed to a qualified tax professional.

Tax Deferral

One of the primary benefits that make annuities a desirable investment vehicle is the fact that all annuities are considered tax-deferred. Tax-deferred means that you do not owe taxes on the account year after year, only when money with withdrawn from the account.

You might be asking yourself, “This sounds just like my IRA, which is, by nature, already tax-deferred… why is this beneficial to me?”

That is a great point. To put an IRA into any type of annuity merely for the tax-deferred benefit just doesn’t make any sense. Putting an IRA or any other type of qualified account into an annuity should be done so for reasons other than tax deferral, such as principal protection, a fixed interest rate, income, etc.

Now, if you are putting a taxable brokerage account into an annuity merely for the tax-deferred benefit, then that makes logical sense. It is not uncommon to see taxable accounts in variable annuities (more on this specific type of annuity in a future post).

Tax Categorization

There are two tax categories that annuities fall into: qualified or non-qualified.

Qualified Annuities

Qualified annuities are purchased with pre-tax dollars. These accounts are funded as IRAs, 401(k)s, 403(b)s, TSPs, lump-sum pension funds, etc., thus they must be individually owned.

New funds that are added to these accounts are subject to certain income eligibility rules and contribution amounts. Qualified annuities are accounts that have never been taxed and will only be taxed when money is distributed from the account. All distributions from these accounts come out taxable as ordinary income in the year they are withdrawn.

Roth IRAs are also a type of qualified annuity. However, as is the case with Roth accounts, withdrawals from these accounts will come out tax-free.

Non-Qualified Annuities

Non-qualified annuities are purchased with dollars that have already been taxed, such as money from your bank savings account or from your brokerage account. Unlike the qualified accounts above, these can be individually or jointly owned.

From a tax accounting standpoint, these accounts will grow tax-deferred and come out taxed as ordinary income in the year the money is withdrawn. This is different from an individual or joint brokerage account where you will very likely be taxed year after year. In the case of non-qualified annuity withdrawals, they will be taxed as either short-term or long-term capital gains, not as ordinary income. This is an important difference between a brokerage account and a non-qualified annuity that investors should be aware of.

Also, the money that is withdrawn from a non-qualified annuity comes out LIFO (Last In, First Out), meaning that you will always be required to take out interest earned before accessing your principal.

Additionally, unlike a taxable brokerage account where you can access your funds at any time, non-qualified annuities require you to be 59.5 before you withdraw funds from the account. Otherwise, you’ll be hit with a 10% tax-penalty.

A Quick Note on Death and Taxes for Non-Qualified Annuities

A significant difference between a taxable brokerage account and a non-qualified annuity lies in the way that accounts are handled at the death of the owner.

In a taxable brokerage account, a beneficiary might choose to utilize what is known as a “step-up” in cost basis. Essentially, this allows the beneficiary of this type of account to all but erase the tax burden on the account up to the day the owner dies. However, this is not how it works for an annuity. Any deferred earnings (interest) will be taxed as ordinary income for the non-spouse beneficiary. This is something that non-spouse beneficiaries should be aware of.

In the next article on annuities, we’ll take a closer look at the four main types of annuities: immediate, variable, fixed-interest and fixed-indexed.