Friday, January 8, 2010

Annuity Taxation

Annuities are tax advantaged vehicles that aid in tax planning when handled correctly. Money invested in an annuity is not deductible unless it is a traditional IRA contribution meeting the qualifications of a deductible IRA. For this blog post, I am talking about non-IRA annuities.

Money withdrawn from an annuity is taxed one of two ways: 1.) all the profit first and then principle, or 2.) profit is taken pro-rata. Lump-sum distributions from an annuity come from taxable profit first and then principle, which has already been taxed and will NOT be taxed again. If you annuitize (take a stream of income), principle and profit come out in proportion to the account value. In English: If you have a 25% gain in your annuity and annuitize, then only 25% of the payment is taxable income and 75% is a return of your own money.

Unlike a traditional IRA, there is no requirement to withdraw money at a certain age. You can let the money grow tax deferred as long as you like. The biggest drawback of annuities is cost. The internal expenses of annuities make them a last resort for tax planning. There are many other ways to invest and save taxes before you consider annuities.

If you already own an annuity, be careful about cashing it in. If you are under age 59 1/2 you will be hit with a tax penalty on the gain. I recommend you consult your friendly accountant, one that doesn't sell insurance, mutual funds, or investments, to review your options.

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