When you buy a whole life annuity, you are entering into a contract with an annuity company. In exchange for your deposit, the annuity company agrees to give you payments for the rest of your life. The IRS created several tax benefits for the whole life annuity to help Americans plan for retirement. The exact tax consequences of your annuity depend on how you funded the contract and how you take out your money.
When you put money in a whole life annuity, the annuity company invests your deposit. A fixed annuity pays a guaranteed interest rate on your account, whereas a variable annuity puts your money in the stock market. As long as your investment gains stay in the annuity account, you don't owe any income tax. You only need to pay taxes on your investment gains when they are paid out of your contract. This helps the investments in your whole life annuity grow faster than a regular taxable account.
You can fund your whole life annuity with either pretax or after-tax dollars. A qualified annuity is funded with pretax money. This happens when you roll over a 401(k) or IRA into a whole life annuity. The whole life annuity continues to delay taxes on your retirement savings while they are in the annuity contract. When a qualified annuity gives you a payment, the entire payment is taxable. Since you never paid taxes on your annuity contributions or your investment gains, you owe those taxes when the money is paid out.
A non-qualified annuity is funded with after-tax dollars. The IRS doesn't double tax your annuity contributions. You get your contributions back tax-free and only owe income tax on your investment gains. When you receive a payment, the IRS calculates the taxable amount by looking at the ratio of investment gains to contributions in your annuity. For example, if half of your annuity balance came from your deposits and half from your investment gains, you would need to report half of your annuity payments as taxable income and the rest would be tax-free.
While a whole life annuity is supposed to last your entire life, you can cancel the contract early and take out your money; however, this can get expensive. When you cancel your annuity, you immediately owe income tax on all your investment gains and pretax contributions. If you are younger than 59 1/2, you'll also owe an extra 10 percent penalty on the investment gains and pretax contributions. Lastly, you could owe an early surrender charge to your annuity company. Annuity companies typically charge an extra fee if you end a contract within its first five to seven years.
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