An annuity addresses a common retiree dream: monthly income you can't outlive. Contributions to a "qualified" annuity are funded with pre-tax dollars, meaning you deduct them from your gross income. However, you pay post-tax dollars into "nonqualified" annuities – contributions to this annuity type are not deductible.
Selecting an Annuity
Insurance companies sell annuity contracts. You build up the cash value of an annuity through one or more contributions, called premiums. At a future date, you can begin drawing monthly payments that may be guaranteed for life. You must be at least 18 years old to buy an annuity.
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Your investment options for an annuity contract depend on several variables, including the type of annuity, the contract's terms and your preferences. Fixed annuities don't give you any flexibility – your premiums earn a set interest rate. Variable annuities offer more choices, but these choices vary by contract. Your annuity contract might pay a death benefit to beneficiaries.
All annuities allow your contributions to grow tax-deferred until distributed. All distributions from a qualified annuity are taxed as ordinary income, whereas only the amounts above the cost basis (i.e., contributions) distributed from a nonqualified annuity are taxable.
Read More: How Old Do You Have to Be to Buy an Annuity?
Understanding Qualified Annuities
You hold a qualified annuity in a retirement account, such as an IRA, 401(k) or 403(b). Your contributions to a qualified annuity are subject to the retirement account's rules and limits, including the following:
- Each year, you can contribute to a qualified deferred annuity up to the retirement account's annual limit.
- Contributions receive a retirement annuity tax deduction, subject to the same rules that govern all contributions to the retirement account.
- The annuity grows tax-deferred until you receive its proceeds, as a lump-sum or as periodic payments for a set period or the rest of your life. You include the proceeds in your ordinary taxable income for the year.
- You can contribute the lesser of your annual compensation or $6,000 ($7,000 if you are 50 or older) to an IRA in 2022, including any qualified annuity contracts contained within the account.
- The maximum amount of your compensation that you can contribute to an employer 401(k) or 403(b) retirement account in 2022, including any annuity contracts within the account, is $20,500 ($27,000 if 50 or older). Your employer can also contribute to your account, but total contributions cannot exceed the lesser of $61,000 ($67,500 if over 50) or 100 percent of your compensation.
- Qualified annuities are subject to the same early withdrawal penalty and required minimum distribution (RMD) rules as other investments in retirement accounts. You must take distributions no later than April 1 of the year following the one in which you attain the age of 72. However, if you are still employed by the sponsor of your qualified workplace retirement plan, you can postpone RMDs until you separate from the job.
- The annuity may have a "period certain," such as 10 years, meaning distributions must continue for no less than 10 years, even if you die.
Read More: Characteristics of an Annuity
Tax Considerations for Nonqualified Annuities
You purchase nonqualified annuities directly from insurance companies. You can select contracts that give you complete freedom to choose your investments, and you may invest any amount you want in a nonqualified annuity, subject to the insurer's requirements.
Contributions to a nonqualified annuity aren't eligible for the annuity tax deduction, which means they create a cost basis. You only pay taxes on the surplus of the money paid out by the annuity over the cost basis.
The IRS General Rule describes how to figure taxes on nonqualified annuity distributions. The early withdrawal penalty, with exceptions, applies to nonqualified annuities, but the age 72 required minimum distributions rule does not.