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Annuities are the only financial product on the market specifically designed to convert a lump sum to a guaranteed income. As such, they are powerful tools for hedging against uncertainty and risk. But they also come with powerful tax advantages as well.

The Power of Tax Deferral

Tax deferral is a powerful tool that an investor can use to magnify potential returns - over and above what you might gain using similar investments in a taxable account. Any tax you can put off paying to Uncle Sam is equivalent to taking an interest free loan from the government - and investing it.

For example, if you make a series of investments that generate $1,000 per year in the first year in interest income and you held those in a taxable account, you would likely have to pay $250-$280 to the IRS in income taxes. You would only be able to reinvest $720-$750 of that money and let it compound over time. By holding those same investments in a tax-deferred vehicle, however, you get the benefit of compounding the entire amount - year after year after year.

As investment mogul Warren Buffett has noted, this is the same as the government handing you that extra amount to invest - with no payments and no strings attached, as long as the money stays in the annuity. Yes, you pay income tax on gains - eventually - but you get to decide when, subject to RMD rules.

Annuity Taxation Basics

As long as the annuity owner is still living, they are taxed very similarly to traditional IRAs with nondeductible contributions, and have many of the same tax advantages.

• There is generally no up-front tax deduction on premium (unless you hold the annuity in an IRA).
• There is no capital gains tax. You can exchange from annuity to annuity as much as you like, using Section 1035 of the U.S. Tax Code, without worrying about capital gains or losses). If you just used mutual funds outside of a retirement account, you'd have to pay capital gains taxes on any net gains each year.
• There are no taxes on dividend income.
• There is no tax on interest income.
• Distributions are taxed as ordinary income.
• You don't pay taxes on the entire distribution - only the part attributable to growth from non-deductible contributions.
• You must begin taking distributions by April 1 of the year after the year in which you turn age 70½.
• Annuity Taxation At Death
• The tax treatment of annuities depends on whether the annuity was still in the growth phase, or began paying out income benefits. If the owner dies before the annuity started paying an income, the beneficiary has several choices:
• Keep the annuity contract intact and treat it as his or her own (an option for surviving spouses only).
• Surrender the contract, take the cash immediately and pay income taxes.
• Spread out withdrawals over five years (similar to inheriting a non-spousal IRA)
• Let the contract continue to grow tax-deferred, and then take the entire annuity income at that time.
• Annuitize the inherited annuity and take payments over his or her life expectancy. This allows much of the annuity to grow tax-deferred over a lifetime! You must make this election within 60 days of inheriting an annuity, however.
• In addition, surviving spouses who inherit an annuity have these options:
• Keep the annuity contract intact and treat it as his or her own.
• Annuitize the inherited annuity and take payments over his or her life expectancy. This allows much of the annuity to grow tax-deferred over a lifetime! You must make this election within 60 days of inheriting an annuity, however.

If the annuity has already started paying out income, the beneficiary must continue to take the income at least as fast as the annuitant was taking income.
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