The Tax-Deferred Annuity

Shawn Plummer

CEO, The Annuity Expert

When planning for retirement, one of the most important things to consider is ensuring you have enough money to live comfortably throughout your golden years. One way to do this is by investing in a tax-deferred annuity. But what exactly is a tax-deferred annuity, and how does it work? This guide will explore the basics of tax-deferred annuities, including what they are, how they work, and which types are tax-deferred.

What Are Tax-Deferred Annuities?

A tax-deferred annuity is a type of investment vehicle that allows you to save money for retirement on a tax-deferred basis. In other words, you don’t have to pay taxes on the money you contribute to the annuity until you withdraw it in retirement. This can be a valuable feature for those who want to maximize their retirement savings and minimize their tax liability.

Fixed annuities

Fixed annuities are tax-deferred annuities that guarantee a fixed rate of return for a fixed period of time. This means your investment will earn interest at a predetermined rate, regardless of market fluctuations. Fixed annuities are often popular for those who want a steady and predictable retirement income source.

Variable annuities

Variable annuities, on the other hand, allow you to invest in various underlying assets, such as stocks, bonds, and mutual funds. The return on your investment is not fixed but somewhat dependent on the performance of the underlying assets. While variable annuities offer the potential for higher returns, they also come with more risk than fixed annuities.

How Does A Tax-Deferred Annuity Work?

A tax-deferred annuity allows you to invest a certain amount of money each year up to a specified limit. This money grows tax-free until you withdraw it in retirement, at which point it is subject to ordinary income taxes. The same tax treatment of your withdrawals will depend on several factors, such as the type of annuity you have, how long you have held it, and the age at which you begin taking withdrawals.

A tax-deferred annuity works as follows:

  1. An individual invests a lump sum or makes periodic contributions to the annuity.
  2. The funds are invested, typically in a mixture of stocks, bonds, and a fixed interest rate, and grow over time on a tax-deferred basis.
  3. The investment gains are not taxed until the individual withdraws the funds, usually in retirement.
  4. Upon withdrawal, the individual pays taxes on the investment gains as ordinary income.

By deferring taxes until withdrawal, the investment grows faster because the funds are not reduced by taxes yearly.

Contribution limits

The IRS limits your contribution to a qualified tax-deferred annuity each year. These limits can change yearly, and they may differ for different annuities. For example, in 2023, the contribution limit for a traditional IRA is $6,500, while the limit for a 401(k) plan is $22,500.

Nonqualified tax-deferred annuities have no contribution limits because they are funded with after-taxed funds such as cash and personal savings.

Withdrawal options

When you reach retirement age, you can begin taking withdrawals from your tax-deferred annuity. The amount you can withdraw each year will depend on several factors, including the type of annuity you have, how long you have held it, and your age at the time of withdrawal. Some annuities may also offer options for lifetime income, which can provide a steady income stream throughout your retirement.

Surrender charges

Some tax-deferred annuities may also have surrender charges, which you must pay if you decide to withdraw money early. These charges may vary depending on the type of annuity and the length of time you have held it. Therefore, knowing any surrender charges before investing in a tax-deferred annuity is essential.

Which Annuities Have Tax Deferral?

Not all annuities are tax-deferred, so it’s essential to understand which types offer this feature. Generally, fixed and variable annuities are the most common tax-deferred annuities.

Mult-Year Guaranteed Annuities (MYGA), fixed indexed annuities, variable annuities, RILA annuities, and long-term care annuities are popular investments because of their tax-deferral benefits.

The tax deferral associated with these products can provide enormous savings for people looking to build wealth or prepare for retirement.

  • A MYGA is a fixed annuity that provides individuals with a guaranteed rate of return on investment over set periods ranging from two to 20 years.
  • Fixed index annuities combine the features of both fixed and variable annuities, offering certainty and moderate risk for a fixed period of time while also providing potential upside.
  • Variable annuities offer some protection due to contractual guarantees contingent upon market performance and age.
  • Registered Index-Linked Annuity (RILA) contracts combine the features of both fixed-indexed and variable annuities providing investors with more choices in their investments while also offering tax-advantaged growth.
  • In addition, choosing long-term care annuities as an alternative to long-term care insurance helps protect people from risks associated with uncertain health during retirement.

All five types of investments allow investors to maximize their returns by deferring taxes until withdrawals occur, thus creating substantial advantages for those investing for the long term.

Which Annuities Do Not Offer Tax-Deferral?

Immediate annuities are the annuities that do not offer tax deferral. An immediate annuity is when the individual makes a lump sum payment in exchange for guaranteed, periodic payments, starting immediately.

The payments from an immediate annuity are taxed as ordinary income in the year received. However, the investment gains are not tax-deferred and are taxed as ordinary income in the year received.

Immediate annuities are often used as a source of income during retirement.

Is A Tax-Deferred Annuity A Good Idea?

Whether a tax-deferred annuity is a good idea depends on several factors, including an individual’s investment goals, financial situation, and risk tolerance.

Some potential benefits of a tax-deferred annuity include tax-deferred growth, guaranteed income in retirement, and the potential for higher returns compared to traditional savings accounts.

However, it is essential to consider the fees, potential withdrawal restrictions, and the long-term impact of taxes when evaluating whether a tax-deferred annuity is a good idea.

It is recommended to consult a financial advisor before deciding on a tax-deferred annuity.

Next Steps

Annuities are a great retirement planning tool because they offer several benefits, including tax-deferred growth. This means you can let your money grow without paying taxes on it every year. Different annuities offer this benefit, and this guide has outlined how they work. Contact us today if you want to learn more about annuities or get a quote. We would be happy to help you plan for your retirement!

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Frequently Asked Questions

Is a 403b a tax-deferred annuity?

Yes, a 403b is a type of tax-deferred annuity. It is a retirement savings plan offered by tax-exempt and non-profit organizations, allowing eligible employees to save for retirement on a tax-deferred basis and potentially receive employer contributions. The investment earnings grow tax-free until withdrawal, when the individual pays taxes on the funds as ordinary income.

How much can I put into a tax-deferred annuity?

The amount an individual can contribute to a qualified tax-deferred annuity is subject to annual contribution limits set by the Internal Revenue Service (IRS). There are no limits to nonqualified annuities.

Are fixed annuities tax-deferred?

Yes, fixed annuities are typically tax-deferred. A fixed annuity is an insurance contract in which an individual makes a lump sum payment or series of payments in exchange for a guaranteed rate of return over a specified term. The investment gains grow tax-deferred until withdrawal when the individual pays taxes on the funds as ordinary income.

Are all variable annuities tax-deferred?

Yes, variable annuities are typically tax-deferred. A variable annuity is a type of investment product where the individual can invest in various sub-accounts, similar to mutual funds, and the investment gains grow tax-deferred until withdrawal. At that point, the individual pays taxes on the funds as ordinary income.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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