Annuities are insurance policies that grow in a similar manner to retirement accounts. Your purchase premiums are sheltered from state and federal taxes during the annuity term so you pay nothing until you actually make withdrawals. As with other types of tax-deferred accounts, you incur a hefty penalty if you cash in your contract before you reach retirement age.
Annuities take one of two forms: qualified or non-qualified. From a federal tax perspective, qualified funds are sums of money that have never been subjected to income tax. Therefore, a qualified annuity could contain money that you rolled over from a pension, or individual retirement arrangement (IRA) money. A non-qualified annuity contains money that you paid tax on prior to purchasing the annuity. Both qualified and non-qualified annuities grow tax-deferred, but when you make withdrawals you have to pay income tax on any money that was not taxed before entering the contract.
You have to pay a 10 percent federal tax penalty if you access qualified or tax-deferred funds before reaching the age of 59 1/2. On a qualified annuity, you pay this penalty on your entire withdrawal. You also have to pay federal income tax and state income tax on the money, so if you fall into a high tax bracket you could lose half of your money to taxes. On a non-qualified annuity, you pay the same taxes and incur the tax penalty if you make withdrawals prior to age 59 1/2, but you only pay these taxes on the account earnings.
You do not have to pay the 10 percent penalty on premature annuity withdrawals if you are the contract beneficiary and receive the funds as a result of the death of the contract owner. You can also access funds without penalty if you become disabled. Finally, you pay no penalty if you withdraw the money as a series of roughly equal payments designed to last for the duration of your life. However, while you avoid the 10 percent penalty in these situations, you do still have to pay ordinary state and federal income tax.
Taxes hit you harder when you make a withdrawal from a non-qualified annuity than when you access money from Roth IRAs that are also funded with after-tax money. If you make a partial Roth withdrawal, the IRS allows you to get back your principal before you access your earnings. This means you only pay taxes if you withdraw more than you originally invested. With annuity withdrawals you have to withdraw your earnings first, which means you have to pay income tax on your withdrawals up until you only have principal left in the account. The IRS calls this taxation method the last-in-first-out method. However, LIFO applies, whether you access your money before or after reaching retirement age.
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