Individual retirement accounts and annuities allow you to save for your retirement and secure your financial future. Regardless of which type of IRA or annuity you have, you are not required to pay taxes on the interest you earn annually from investments in these instruments. IRAs and annuities both offer tax-deferred savings opportunities for investors. Once you retire, taxes may be assessed, depending on the type of retirement account you hold.
A traditional IRA is funded with pre-tax earnings. You can contribute 100 percent of your income, up to a specified dollar amount, to a traditional IRA each year. At the time of publication in July 2012, if you're under age 50 you can contribute $5,000 per year. If you are over 50, you can contribute an additional $1,000 annually. Money accumulates interest, or earnings, in the IRA, but you are not required to report the earnings each year. Taxes on the contributions and earnings are deferred until you make qualified withdrawals, which you can do after age 59 1/2. At that time you pay income tax at your regular rate on whatever you withdraw. If you withdraw before age 59 1/2, you face a 10 percent tax penalty on top of regular income taxes on the amount.
Roth IRAs are funded with money that has already been taxed. The same contribution limits as those for traditional IRAs apply. If you invest in a Roth IRA, you are not required to declare the distributions on your taxes since you already paid taxes on the funds during the years you earned them. The main advantage of a Roth IRA is that you never pay taxes on the gain, as long as the money has been in the IRA for at least five years and you take distributions after age 59 1/2. This arrangement allows your contributions to grow tax-free.
An annuity is a contract with an insurance company. In exchange for your money, the insurance company promises to pay back your principal along with interest throughout the rest of your life. With an immediate annuity, your lump sum of money is invested and converted to a steady steam of income, and payments begin right away. The amount of each payment is based on your life expectancy. Another option is a deferred annuity. If you do not have the cash on hand, you can make payments to build the principal. When you retire, the annuity begins paying you income. To receive annuity income, you must be at least 59 1/2. Early withdrawals result in a possible 10 percent tax penalty.
Qualified and Non-Qualified Annuities
Annuities are classified as qualified or non-qualified. A qualified annuity is purchased as part of an employer-provided retirement plan or IRA. Contributions to qualified annuities may be entirely or partially deductible from your taxable income. Distributions from a qualified annuity are taxed as income when you retire. A non-qualified annuity is one purchased privately. It is not part of an employer-provided retirement program. These contributions are not tax-deductible. When you buy an immediate or deferred non-qualified annuity, you pay ordinary taxes on the interest when you begin receiving distributions at retirement. The principal is not taxable because it is a return of your initial investment. In addition to the IRS 10 percent tax penalty for withdrawals before age 59 1/2, annuity companies can also charge you for early withdrawals or cancellations, even if you meet the age requirement. Most annuities have a surrender period, which is a set amount of time you are required to keep the majority of your money in the contract. Typically, a surrender period lasts from five to 10 years. The surrender charge starts at around 7 percent and declines throughout the surrender period.
Jeannine Mancini, a Florida native, has been writing business and personal finance articles since 2003. Her articles have been published in the Florida Today and Orlando Sentinel. She earned a Bachelor of Science in Interdisciplinary Studies from the University of Central Florida.