Annuities are often overlooked as a tool to include in retirement savings strategies, mainly because of their complexity. It’s true that they aren’t right for everyone, but for those who can utilize them, there are some key benefits. The ability to grow your money on a tax-deferred basis while generating a reliable income stream in the future is one of them. If you’re considering adding an annuity to your portfolio, take a few minutes to learn more about the tax advantages of these retirement tools.
The money that you contribute to an annuity is not tax-free, but once it’s been invested in the contract, it can grow on a tax-deferred basis. This means that you won’t have to pay any taxes on investment gains along the way. Annuities are similar to other popular retirement savings options like IRAs and 401(k)s. The main difference between these two tools is that you don’t have to worry about annual contribution limits with annuities. At this time, employees under 50 can contribute up to $5,500 a year to an IRA and $18,000 a year to a 401(k). Those limits increase to $6,500 and $24,000 respectively for those 50 and older. While those limits may not be an issue for some investors, higher earners may find them quite restrictive. With an annuity though, you can contribute as much as you’d like while taking advantage of tax-deferred growth.
It’s important to keep in mind that while money in an annuity grows on a tax-deferred basis, withdrawals aren’t necessarily tax-free. Typically, annuities are taxed on a last-in, first-out basis. This means that the funds that your first withdraw from an annuity, the money you receive is considered earnings and taxed as ordinary income. But once the value of your annuity falls below the amount you paid into it, you then take withdrawals tax-free.
Another consideration is that annuities usually don’t impose minimum required distributions like IRAs and 401(k)s do. With a traditional IRA or 401(k), you must start taking money out of your account once you turn 70 ½. Failing to do so could result in a 50% penalty on the amount you should have withdrawn. The required minimum distribution subjects you to extra taxes and also limits your growth potential. As long as you don’t hold your annuity in an IRA, you won’t be subject to the same required minimum distribution.
While these tax benefits are enticing, annuities also have their drawbacks. If you take money out of an annuity before reaching the age of 59 ½, you’ll pay standard 10% early withdrawal penalty. The same holds true for IRAs and 401(k)s. Annuities also usually come with annual fees that can reduce your returns. Still, if you’re looking to save more for retirement, but have already maxed out your IRA or 401(k) contributions, take the time to look into an annuity. It might be the perfect tool for you.
Written by Rachel Summit