It’s pretty interesting to see that so many investors don’t know how annuities are taxed. It’s interesting, but not in a good way. This is something that investors should understand before they get involved, however most learn it after they’re already locked in. Tom and Brendan talk about annuities and how they’re taxed in this Mullooly Asset Management podcast.
A big selling point that many people hear about annuities is that, “there won’t be a 1099 involved!”. The question investors should be wondering is, “When and how will I be taxed on this investment in the future?”, because we all know that taxes on gains are inevitable. Their money will be growing tax-deferred (not tax-free) until they take money out. However, when they do take that money out it will be taxed as ordinary income, not as capital gains. Capital gains are taxed at much lower rates than ordinary income.
Tom and Brendan go over the different ways in which money might be withdrawn from an annuity, and how taxes would be applied in those situations. If the money is taken out in a lump sum, the gains are taxable as ordinary income. This means the difference between what you started with in the annuity and what it is worth on the day of withdrawal will be taxable. If the money is taken out as a monthly distribution, also known as annuitizing, then each distribution is considered part ordinary income, part principal. Principal is not taxed, but the rest will be.
A lot of people also wonder what happens when the annuity owner passes away. If the annuity hasn’t been annuitized yet, the money will go to the designated beneficiaries. The beneficiaries will then have five years to get the money out of the annuity, and the gains will be taxed as ordinary income when they do so. If the contract has been annuitized, two things can happen. If the owner chose to paid over their lifetime, those payments cease. If the owner chose to be paid over a set period of time, payments will continue for that amount of time to the designated beneficiaries. As with all the other scenarios, the gains will be taxed as ordinary income, not capital gains.
The main thing to take away from this week’s podcast about how annuities are taxed is that investors should be asking the right kinds of questions before they get involved with any investment. Don’t get left with surprises when it comes to your investments. You should understand how annuities and all other types of investments are taxed before putting your hard-earned money into them.