Consider the totality of annuity taxation before you buy one for its tax benefits.
Annuity contracts are complex, and we strongly suggest you consult a tax advisor if you are considering purchasing an annuity. Though the following shouldn’t be construed as tax advice, we hope these points about annuity taxation help begin the conversation with your tax professional.*
If you are considering an annuity for supposed tax advantages, be wary if your broker represents annuities as a sure way to lower your tax bill. Annuities don’t always lead to lower tax bills and may instead offer a host of disadvantages which could prevent you from reaching your goals—even if you do manage to eke out a small tax benefit.
While it is true that annuities offer tax-deferred growth, plenty of other factors could curtail that advantage such as high fees, weak returns and possible penalties for early withdrawals. Some other possible disadvantages of annuity taxation are that annuity gains are taxed as ordinary income and not capital gains, plus the gains don’t receive a cost basis step up like many other investments when an investor passes away.*
Annuity taxation is complicated. Don’t step into the annuity trap by failing to consider how annuities could potentially make it more difficult to pay future tax bills.
Before we review annuity taxation, here’s a brief reminder of all annuities’ similar two-part structure:
For more on annuities, we encourage you to read our guide "Annuity Insights: 9 Questions Every Investor Should Ask."
Most insurers offer investors the option to purchase additional “rider” contracts with their variable and indexed annuities. Such riders can include a lifetime pay-out, a joint lifetime pay-out and minimum income guarantees. The benefits offered through riders can be very popular, but usually each rider comes with an additional fee. These fees can eat into the annuity’s growth. Be careful when weighing the potential benefit of each rider relative to its cost. Specific contract terms can vary depending on the insurer who offers the annuity. Make sure to read all the supporting materials connected with the terms thoroughly to know exactly what you’re getting into.
If you listen to some brokers, you might hear that the taxation of annuities offers a real advantage over other investments. But the real story goes deeper than what you’ll hear from your broker. The benefits of annuity taxation might not be substantial enough to make up for the annuity’s fees, investment returns and other issues.
An annuity’s tax structure depends on the account where it’s held. If you buy an annuity through a tax-deferred retirement account, like an Individual Retirement Account (IRA) or a 401(k), you’ll pay taxes on the annuity during your ongoing payout period. However, if you buy an annuity through a Roth IRA, you’ve already paid the income tax, and taxes on the annuity won’t be deferred. This means you won’t need to pay taxes when you reach annuitization*.
Alternatively, a lot of investors buy annuities in regular, taxable accounts. How does annuity taxation work in this case? Typically, the earnings the annuity accumulates gets taxed, and the principal does not. This is similar to a capital gains tax, in that you only pay taxes on the amount your investment earned (also known as your return on principal). The difference is that with annuities you face ordinary income tax rates, as opposed to (usually lesser) capital gains tax rates. Your broker might try to sell this to you as an annuity taxation advantage and use a phrase like “return of principal.” However, “return of principal” is simply the annuity company giving you back your own hard-earned money.
If all this sounds complicated, we agree. But there’s more.
Your age when you buy your annuity can also affect the accounting rules used to determine the annuity’s taxation. And if you need to surrender the annuity before you reach age 59.5, you generally will pay the regular taxes on the gains and an early withdrawal penalty.
Let’s go back now to what your broker might have told you. You probably heard what sounded like a big advantage in relation to how an annuity handles taxation. Unfortunately, as with most annuities, it’s not that simple.
First, remember that with annuities, taxes (assuming you buy an annuity in a taxable account)—will typically be paid on the gains. If it is a normal distribution, as opposed to an annuitized payment, then the gains will generally be distributed first. That’s because annuities typically operate under a “last in, first out” (LIFO) principle, in which earnings are taxed first, as ordinary income.
If the distribution is annuitized and there are gains in those payments, then a portion of the annuitized payout is taxed, usually based on what percentage of the total portfolio consisted of gains when annuitized. For example, if you have a $200,000 portfolio that includes $100,000 in gains, then 50% of the account was a gain. That means when payouts begin on an annuitized payout, 50% of each payment would be considered taxable income.
Also, your broker might neglect to mention that when you take money from your annuity at some future date, the distributions will be taxed at your then-current tax rate for ordinary income. Even if your income tax rate is lower during your retirement years than in your working years, it will still likely be higher than the tax rate for capital gains. In other words, from a tax perspective, your money may be better off in an investment account taxed at the capital gains rate than in an annuity taxed at the ordinary income rate.
There are other reasons to be wary about annuities beyond annuities’ taxation. Fisher Investments is committed to helping investors unravel the complexity of annuities to understand them better, through our annuity evaluation service. Clients can request a meeting or browse our annuity literature on demand.
*The contents of this webpage should not be construed as tax advice. Please contact your tax professional.