When planning for retirement, most people consider the overall amount they will need in order to replace their current income, or to reach another desired number. One aspect that is often overlooked is how their income will be taxed when they make withdrawals.
Whether withdrawing from a 401(k), brokerage account or something else, understanding how taxes will impact the total take-home amount is a critical part of planning for the future. Here is what you need to know about how to manage annuity taxes to better help you determine the right product for you.
Are Annuities Taxed?
There are a wide variety of annuity types from which to choose, each with their own advantages and disadvantages. This means that each of them will be taxed slightly differently. Some are even tax advantaged, which means that they behave favorably in regards to taxes compared to products with similar payouts but different legal structures.
Regardless of which type of annuity you select, you should plan to pay annuity taxes on at least a portion of the money at some point. In order to understand more about how to calculate those taxes ahead of time, you will need to decide whether to invest in a qualified or non-qualified annuity.
No one annuity is superior to the other, since they each provide different benefits and are taxed differently, but understanding their differences will help you choose what is best for your goals.
Qualified vs. Non-Qualified Annuities
A qualified annuity is an annuity held inside a retirement account such as a 401(k) or IRA and people often roll 401(k) money into qualified annuities. These funds are qualified, meaning that you can contribute your pre-tax income to them. This money doesn’t even touch your paycheck, because it goes straight to the qualified annuity.
Because of that, taxes have not yet been taken out of the contributions. This means that when you start receiving the money in a qualified annuity, you will need to pay taxes on it just as if it were a regular paycheck. It is taxed as income.
A non-qualified annuity works differently. This is funded with after-tax money—in other words, net income rather than gross. Since you have already paid taxes on this amount, you will not be required to pay taxes on it again later.
When you receive payments from an annuity that is non-qualified, you will only need to pay annuity taxes on anything that accumulated beyond the after-tax money you contributed. Since annuities can grow over time depending on their rate, you may expect some taxes, but not as much as if using a qualified annuity.
MYGA Tax Advantage
The tax payments mentioned above apply to all annuities However, there is another specific type of annuity called a MYGA (multi-year guaranteed annuity) that does not provide you with regular payments.
Instead, the purpose of a MYGA is to provide a secure place for your money to grow before you withdraw it or roll it into a different annuity product, such as a fixed annuity, from which you then start receiving payments.
MYGAs are tax advantaged in multiple ways, the primary of which is that taxes are deferred. Compare a MYGA to something such as a CD (certificate of deposit). In a CD, you will need to pay taxes annually on the gains that accrue—which means that each year, you owe something. Conversely, a MYGA will not create a tax burden on the growth until you receive the money as income.
This is a powerful difference, because it leaves more money in your hands during the process. Pushing taxes off until later results in more substantial growth, because you have a greater balance working for you to accumulate.
You should plan to pay taxes on the accumulation once the term period of the MYGA is done, though rolling the MYGA into another product immediately could change how those annuity taxes are addressed. Be sure to plan accordingly to avoid being surprised by a tax bill.
Factor Taxes into Your Annuity Selection
There is not a completely tax-free annuity, but you do have options to determine how you want to handle those taxes. You are the best person to decide what is right for your future which is why Pillar Life Insurance offers a self-managed online portal where you can make those decisions without a middleman. Take a look at our online questionnaire to get started on your journey toward financial stability and learn more about the products offered, as well as how they will be taxed later.
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