Annuities are contracts sold by insurance companies that provide a guaranteed stream of income in exchange for a one-time or recurring premium payment. A 408b annuity is held inside an individual retirement account to shelter the earnings from taxation until you choose to make a withdrawal. To qualify for this preferred tax treatment, a 408b annuity must meet certain contribution and transferability requirements.
408b annuities combine the tax savings of an IRA with the risk-free earnings of an annuity. Your annuity premiums are deductible up to a specified limit each year. Any interest, dividends or other gains you earn on the account are taxed when you withdraw the money. You can choose a fixed annuity that returns a set rate of interest or a variable annuity with interest that fluctuates along with the stock market.
Contributions to a 408b annuity are subject to the annual Internal Revenue Service limits, which can hamper the amount you are able to accumulate for your retirement. Since your IRA contributions are made on a pre-tax basis, you will be taxed on the entire amount when you withdraw funds. If you had a conventional annuity, you would only be taxed on your earnings because the contributions were previously taxed. This can be an advantage if you expect your tax bracket to be lower in the future. However, this is a disadvantage if you are not close to retirement when you open the annuity. Withdrawals from your annuity are also subject to a 10 percent early withdrawal penalty if you are younger than 59 1/2.
To qualify for tax deferral under 408b, the annuity may not be transferred, forfeited or pledged as security for a loan. Even a transfer of a portion of your interest in the annuity will disqualify the entire contract. You may designate a beneficiary to inherit the annuity upon your death or set up a joint and survivor annuity without disqualification.
If your annuity is disqualified from 408b tax treatment, you will be taxed on its value retroactive to the first day of the tax year in which it is disqualified. The entire fair market value of the annuity on that day must be reported as a taxable distribution on your individual tax return. If you are younger than 59 1/2, you must also pay the 10 percent early withdrawal penalty. The annuity will be permanently disqualified and cannot be requalified by reversing the transfer later.
Denise Sullivan has been writing professionally for more than five years after a long career in business. She has been published on Yahoo! Voices and other publications. Her areas of expertise are business, law, gaming, home renovations, gardening, sports and exercise.