Tax Deferred Annuity

A tax deferred annuity gives you the opportunity to save more for your retirement after you have maxed out your IRA or 401k contributions.

Tax deferred, not tax free

As I mentioned above, tax deferred annuities allow your earnings to accumulate without being taxed until you withdraw money. However, keep in mind that when you begin to generate your retirement income from the annuities, you must then pay ordinary income taxes on your tax deferred earnings.

Annuities are purchased for the purpose of accumulating money for retirement. To accomplish your retirement goal, you need time for compound interest to multiply your savings. The deferral of income taxes gives you time to accumulate a block of money that is intended to be used to provide income in the future. The larger the fund base, the greater the income.

Taxes on withdrawals

When you withdraw money from your tax deferred annuity, the withdrawals are considered as coming from earnings first, then from contributions. You must pay income taxes on the part that is considered earnings. On the other hand, you will not have to pay taxes on the withdrawals exceeding earnings because they will be considered as a return of the premiums you have paid.

If you annuitize your annuity to generate lifetime income, you will pay taxes on annuity payments according to the exclusion ratio determined by dividing your original investment by the total amount you expect to a receive during the payout period. Each payment consists of a taxable payment of interest and a tax-free payment of your principal until all of your principal has been returned.

Estate tax

If you die with balance remaining in your annuity, the money will go directly to your specified beneficiaries. Therefore, with an annuity, you can avoid probate if the proceeds are payable to beneficiaries other than your estate. Probate is the legal process of administering the estate of a deceased person. Typically, probate ties up your assets for several months, sometimes even a year and probate fees may take up a large chunk out of your estate.

Although the death benefit avoids probate, the total value of your annuity is generally subject to estate tax and your beneficiaries will inherit all the taxes on the earnings portion of the proceeds that you have deferred. Therefore, using an annuity to fund a Roth IRA may be a good way to pass along a large amount of money and avoid probate because your beneficiaries won't have to pay any income tax on withdrawals from the inherited Roth account.