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Annuities and Taxes: Here’s What You Need to Know

March 1, 2021 by Tamila McDonald Leave a Comment

Annuities can be a reliable source of income in retirement. Once you begin receiving benefits. You’ll receive a set amount of money each month or year for the rest of your life. Even if you live for decades more. However, annuities can come with tax implications. Both on the front and back ends. If you want to find out more about annuities and taxes. Here’s what you need to know.

Annuities and Taxes – Qualified vs. Non-Qualified Annuities

First, it’s important to understand that how an annuity is taxed does vary depending on the type of annuity involved, especially how it was funded.

Qualified annuities are funded with pre-tax dollars. In most cases, these involve principal payments from a type of tax-deferred retirement account, like a 401(k) or a traditional IRA. However, there may be other approaches available, as well.

When you make withdrawals from a qualified annuity, you pay taxes on the money just as you would other traditional kinds of income. Since none of the money has been taxed, every dollar in the withdrawal is treated the same.

Non-qualified annuities are funded with after-tax money. With those, when you make withdrawals, you’ll only owe taxes on earnings, not the deposited amounts. The money used to fund the annuity has already been taxed, so it won’t be taxed again. However, the earnings haven’t, making them subject to taxation.

Usually, with non-qualified annuities, the taxed amount is determined by the exclusion ratio. This calculation determines how much of an annuity income payment is taxable by separating the portion of the payment funded with the principal from the part funded by interest earnings.

In some cases, annuities purchased with funds from a Roth 401(k) or Roth IRA are tax-free. However, very specific conditions have to be met for that to happen.

Tax Rates on Annuities

When you’re receiving income from an annuity, the taxable amount is taxed based on traditional income tax rates. Annuities aren’t eligible for capital gains rates, which are often lower than income tax rates.

If you need to estimate how much you’ll owe, use the traditional tax tables from the IRS. That will give you the most accurate picture, at least on a federal level.

In some cases, you’ll also need to pay taxes on the state level. State income tax rates vary, and some may exclude annuities – as well as other kinds of retirement income – while others do not. Additionally, not all states have an income tax in the first place. As a result, you’ll need to research rules in your area to determine how much you may owe.

Depending on where you purchase your annuity, you may also owe a state premium tax. Some states tax insurance premiums, including during the sale of annuities. If you live in one of those states, you may see a 1 to 3.5 percent tax. However, some states waive the fee under certain circumstances, such as if you make the purchase using funds from a qualified retirement plan.

When Withdrawal Timing Impacts Taxes on Annuities

Another factor in how money from an annuity is taxed is when withdrawals are made. Usually, if you take any money out before you reach the age of 59 ½, you’ll owe a penalty of up to 10 percent to the IRS. However, by waiting until you’re at least 59 ½, you can avoid this entirely.

Additionally, if you take a lump sum instead of annuity income payments, at a minimum, all of your earnings are taxed right away. If you funded the annuity with pre-tax dollars, then the entire lump sum, including both the principal and earnings, are taxed immediately.

Inherited Annuities and Taxes

If you inherit an annuity from another person, the same tax rules apply to you as would to the deceased. As a result, if the annuity was qualified because it was funded with pre-tax dollars, you’ll owe taxes on the entire value of any withdrawals. If it was non-qualified, then you’ll only owe taxes on the earnings.

Ultimately, annuities are fairly simple to understand from a tax perspective. Earnings are typically taxed as income, and withdrawals from principal only are if the annuity was funded pre-tax. While your income tax rates may vary depending on your total income level, how your annuity factors in is reasonably straightforward.

Is there anything else people should know about annuities and taxes? Share your thoughts in the comments below.

Mistakes to Avoid in Retirement

May 27, 2020 by Jacob Sensiba Leave a Comment

In many finance websites, blogs, and articles, a lot has been said about how to prepare for retirement, but I believe there hasn’t been enough written about what to do when you get there. More specifically, there’s a lack of content about mistake, or mistakes, to avoid.

In this article, we’ll explore several mistakes to avoid when you reach this milestone.

Spend beyond your means

This seems obvious, but once the psychological barrier of spending versus savings is breached, people (not everyone) develop this mentality of “I saved for 40 years for this moment, why shouldn’t I enjoy it?”

You should enjoy it. You worked your butt off for it, right? There are strategic ways to do this, however. The mistake is going gangbusters right away.

Create a budget/spending plan – Your budget in retirement will be different than your budget before retirement. Create line items for everything, and get real granular with your discretionary spending (i.e. sub line items to breakdown where the discretionary spending is actually going).
Plan for healthcare – Healthcare costs, generally speaking, will be your largest expense in retirement. Plan accordingly.
Income strategy – More than likely, you’ll have a few different income sources (social security, pension, retirement distributions, etc.). Create a line item for each source.
Senior discounts – Take advantage of every single one. There might be a psychological hesitation with this, as it forces you to come to terms with your age/where you are in life
Spoil grandkids – Every grandparent wants to spoil their grandkids to death, but it must be done within reason. Get creative and be strategic about when and how much.

Make Quick Decisions

Another mistake is making quick decisions. Don’t do it. Any decision you classify as BIG needs to be well thought out. This could be anything like moving, downsizing, vacations, or eliminating a vehicle.

I would argue that any decision about an expense that’s not in your budget/spending plan, should be thought about for several days. My rule of thumb is a week. By then, the euphoria of such a purchase has gone away, then you think more logically about it.

Investing Aggressively

Over the years, a big mistake clients make is the desire to invest more aggressively than they should. Oftentimes, this is to compensate for an inadequate savings rate during their working years or a significant market pullback that hurt their portfolio.

While capital appreciation is still an investment objective in retirement, it’s no longer the primary goal.

This primary goal should be capital preservation. Limiting losses on what you have. This has less to do with time and more to do with your decreasing ability to go out and make more money. Allocate your portfolios accordingly.

Ignoring Estate Planning

Estate planning is a key ingredient to your financial planning recipe. It mustn’t be ignored. Every debt and asset you have needs to be accounted for, listed, and given a task for when you pass.

Estate attorneys can be expensive, but I believe it’s 100% necessary to find one you trust, so your estate is well taken care of.

Isolating Yourself

Your social life is more important than ever. Countless studies show that people with strong relationships outlive those that don’t. So the mistake here is not making your social life a priority.

Join a community, volunteer, retain, and nourish friendships. Whatever flavor of social life sounds desirable, make it a priority.

Letting Yourself Go

Taking care of your mind and body is always important, but especially now. It will keep you healthy, therefore, lowering your healthcare expenditures, but it’s also another way for you to meet people.

Go for walks with neighbors and/or friends. Join a gym. Many of which have reduced rates for seniors. Additionally, many health insurance companies have “silver sneaker” programs that offer inexpensive services and programs for seniors.

Expecting it to be easy

This is a BIG life change and the transition will not be easy.

Not only will you shift from saving to spending, but those social connections you developed over your working years can reduce in frequency and strength.

Go easy on yourself and be patient.

Taking Social Security too early

Unfortunately, there are situations and scenarios where taking Social Security Income (SSI) distributions early is necessary. However, for those of you where this does not apply, speak with a trusted advisor about optimizing your SSI strategy.

Getting Swindled

Scammers adapted. They’re smart and they know how to target susceptible people. Unfortunately, elderly individuals are inherently more at risk than the general population.

Any email, phone call, or text that you receive (unsolicited, of course) should be greeted with a fair amount of skepticism. Don’t willingly give out any pertinent information (name, DOB, social security number, etc.).

Doing it alone

A BIG mistake people make is thinking they can plan by themselves. It would behoove you tremendously to consult with several experts. Estate attorneys and financial advisors should be at the top of this list.

Do your research, check online reviews, and get testimonials from trusted contacts. Having capable professionals in your corner could set you up for success and put your mind at ease.

Just Entering The Workforce? Let’s Talk About Retirement

December 10, 2019 by Susan Paige Leave a Comment

Can you remember the first day you worked and earned money? It might have been babysitting for your neighbor’s kids or a retail job at the local mall. As a kid, you might have imagined your parents going to work as something that just happened. You didn’t think of the financial ramifications or why going to work was important.

The older you got, the more likely you were to start seeing the value of money. Want to go to the movie with your friends? Want to purchase a new video game? All those things cost money.

So, you got a job and chances are, you weren’t the best saver. Money was for activities and fun.

But now that you’re entering the real workforce, there are lots of other things your money is going to such as rent, groceries, utilities, and retirement.

Retirement? But you just started working!

Even though you might be 40+ years from retiring, it’s never too early to start thinking about the day when you hang it up. Below, we have some tips and questions you should be asking yourself and those around you when it comes to your retirement.

Does Your Work Have Retirement Benefits?

While a pension was the norm for your grandparents and maybe even your parents, roughly just 54% of businesses these days offer pension plans for their employees. While that may seem like a solid number, the financial crisis of 2009 put a real dent in those numbers and they have been slow to recover.

While your work may not offer a pension, they may offer other benefits like a 401(k) or a 401(a). 401(a) plans are typically offered by government or nonprofit institutions and participation in these plans is often mandatory. Contributions are determined by the employer and can be either pre or post-tax.

401(k) plans are the opposite. They are more popular in the private sector, don’t have a contribution limit, and participation is not mandatory (although it might be).

Contribution is pretty simple, that you take X amount of money out of your paycheck and put it towards these plans each month. Money accrues and grows over time.

Let’s say you need the money, can you take it? Of course, it’s your money but it comes at a cost. The IRS will take a 20% as a penalty for early withdrawal. There are certain stipulations to withdraw money without the penalty, but they are never guaranteed.

Your Personal Savings

Hopefully, you aren’t living paycheck to paycheck and you’re putting away a certain amount of money each month. That could be saved for an emergency or saving up to make a big purchase.

It’s important to set up a personal savings plan because that money could be put into an individual retirement account (more on that later).

Budgeting is boring but highly necessary. Whatever you’re putting away each month should be treated like your 401(a) or 401(k). It should be untouchable. Make sure to take a certain percentage of your savings and plan to put that towards your retirement.

Individual Retirement Accounts

You might have seen this written as IRA and they are pretty common. The idea is that you yourself put money into a non-Roth or Roth IRA each year (up to $5,500 maximum) and that money is invested.

Many people seek out the advice of financial planners to help them plan a strategy for their IRA. The biggest difference between the two lies within the taxes.

Traditional IRAs mean your contributions are taxed in the year they are made. With a Roth IRA, you’re not going to be taxed when you start making withdrawals.

It’s important to note that not everyone is eligible to contribute to a Roth IRA and access can be restricted if you are using a 401(k).

The best thing to do is to meet with a financial planner and discuss your options. Ask your parents or others who might have a contact they can set you up with. They can help you do much more than just manage your retirement, but help manage your entire portfolio as well and give tips on sound money management policies.

Even though it may seem silly, it’s never too early to start thinking about your retirement.

Image source: Flickr.