How Tax Deferred Annuities Work

So, you want to plan for retirement, and you have decided to start investing. But you hate the idea of having to calculate profits, losses, dividends, interest, and every other minute detail of your earnings every year just to report it to the IRS on your annual return. There must be some simpler way to plan for retirement, right?

You’re in luck because something called a tax deferred annuity allows you to build wealth for the future without being taxed until you withdraw the money upon retirement or whenever you decide to receive payments.

So what is a tax deferred annuity?

To start off, an annuity is a contract with an insurance company which guarantees periodic payments (known as annuity rates) after you reach a certain age in exchange for paying premiums to the company now. The return on your current investment can be grown by indexing the annuity fund to things like stocks, bonds, mutual funds, or simply savings accounts.

Often, an annuity’s growth is taxed for the person who invests in it. However, with a tax deferred annuity, the only time the annuity is taxed is when the annuitant receives payments at a future date. The income is treated as income earned in the year the annuity payment is made, and reported on your tax return.

What are the advantages?

There are a lot of pros and cons of annuities but the major advantage of this annuity is that it doesn’t involve a hectic annual reporting requirement. Instead of buying and selling stocks and other investments every year and having to report the capital gains to the IRS, you can simply let the annuity provider deal with year-to-year investment decisions. You only need to deal with declaring the income when you withdraw it in the future, while still benefiting from growth in the stock market or whatever other investment the annuity you decide to purchase is indexed to.

Additionally, even if you don’t personally have much knowledge on economics and investing, by purchasing a tax deferred annuity you end up getting the advice of financial experts. A large insurance company with an interest in growing its profits as much as possible pays experts to manage the annuity fund, and you benefit personally from their expertise without having to lift a finger to learn about the stock market yourself.

Inheritance Issues

There is only one issue with purchasing tax deferred annuities over other investments like stocks and bonds, and that is the inheritance issue. Usually stocks, bonds, precious metals, and other investments can be passed on to an heir tax-free upon the owner’s death. Unfortunately, annuities are usually subject to the standard income tax when the new beneficiary begins to receive payments upon the owner’s death.

A good way around this is to simply not designate a future beneficiary so that upon your death, nobody is paid. The insurer will then charge a smaller premium since they aren’t promising to pay as much in the future, and you can use the savings on your premiums to set up another tax-free inheritance fund for your family.