Understanding the Taxation of Fixed Index and Multi-Year Guarantee Annuities
If you are thinking of buying—or already own—a Fixed Index Annuity (FIA) or Multi-Year Guarantee Annuity (MYGA), it’s important to understand how deferred annuities are taxed.
A good tax strategy for annuities can make a huge difference in your retirement finances. One mistake can affect how much of your Social Security is taxable or how much Medicare Part B costs.
Let’s walk through the tax qualifications of deferred annuities, how they are taxed, some smart annuity tax strategies that can save you money.
What are Tax Deferred Annuities?
Fixed Index Annuities (FIAs) and Multi-Year Guarantee Annuities (MYGAs) both belong to a larger group called tax deferred annuities.
This means you don’t have to claim your earnings each year as long as the funds remain in an annuity. This is different from other investments like CDs, stocks, mutual funds, and ETFs where you have to claim your earnings (from CDs) or dividends (from stocks, ETFs, etc) each year.
And you can keep this tax deferral going by using a 1035 exchange at the end of your annuity’s term to move it to another annuity.
It’s important to note that the tax deferral of annuities is only beneficial to annuities purchased with non-qualified funds, as qualified funds already have some element of tax deferral.
What is Tax Qualification and How Does It Affect Deferred Annuities?
Tax qualification refers to the type of money used to initially fund the annuity: qualified or non-qualified. To get a handle on the basics, read our article devoted to the tax qualification of annuities.
With deferred annuities, the tax qualification of your annuity will impact how your money is taxed when you withdraw it from the annuity. You can make discretionary withdrawals from a MYGA or turn on an income rider in your FIA. Either way, the type of money used to fund the annuity will impact how the money you receive from your annuity is taxed.
How Are Different Annuity Qualifications Taxed?
First, all taxable annuity income is taxed as ordinary income. You will receive a 1099-R from your insurance company at the end of the tax year telling you how much income you need to claim.
However, there is some variation in how the three annuity qualifications are taxed. These three qualifications are: Traditional Qualified Annuity, Roth Qualified Annuity, or Non-Qualified Annuity.
Annuity Tax Qualification Comparison
| Annuity Type | Traditional Qualified | Roth Qualified | Non-Qualified |
|---|---|---|---|
| Funding Type | Pre-tax: IRA, 401(k), TSP, etc. | Post-Tax: Roth IRA | Post-Tax: Personal Savings, Individual Brokerage Account |
| Taxation of Withdrawals | Fully Taxable | Tax-Free | Partially Taxable |
| How Withdrawals Are Taxed? | Fully Taxable as Income | Tax-Free | Earnings paid out first, taxed as ordinary income. |
| Withdrawals Before Reaching Age 59½ | 10% Penalty | 10% Penalty | 10% Penalty on earnings only |
| Other Rules | N/A | Must Hold At Least 5 Years to Receive Roth Benefits | N/A |
| Required Minimum Distributions (RMDs) | Yes | No | No |
| Gains Additional Tax Advantage From Deferred Annuity? | No (already tax deferred) | No (Roth benefits already apply) | Yes - (defers tax on earnings) |
As you can see, the tax qualification of your funding determines if your income is fully or partially taxable, or even tax-free. If it is partially taxable, your interest is paid out first under Last-In, First-Out (LIFO) rules.
LIFO rules apply to most annuity contracts these days, however, if you purchased your annuity prior to August 14, 1982 different tax rules may apply to you.
Because your earnings are paid out to you first, you can imagine that taking out the full value of your annuity may create a substantial tax burden for you in that tax year. This can have a big impact on your overall finances.
Are There Strategies to Spread Out Taxes from Deferred Annuities?
This is a smart question — and one we get often. Yes! There are absolutely strategies to spread out the earnings you receive from a deferred annuity.
In fact, we’ve dedicated an entire article to this to help you understand how an income annuity can spread out your tax burden while also providing guaranteed income.
You can even set up this income stream to last the rest of your life, providing guarantees in your retirement, even in the face of market uncertainty. Many of our clients value these guarantees because they bring peace of mind to them in retirement, allowing them to redirect their focus from their finances to their interests, hobbies, and families.
Is It A Good Idea to Buy An Annuity with IRA Money?
Although you won’t get additional tax deferral by using qualified funds (like an IRA or 401k), you’ll still receive the annuity’s other contractual benefits.
Deferred annuities like MYGAs are growing in popularity because they have competitive interest rates and are a relatively conservative investment. For many retirees, having their money earn guaranteed interest from a reputable company is integral to their retirement plan and peace of mind.
In fact, many retirees put both qualified and non-qualified funds into annuities as a part of a larger strategy that includes things like reducing interest rate risk and managing required minimum distributions.
Need Help Understanding the Taxation of Fixed Index and Multi-Year Guarantee Annuities?
That’s where we come in. Our U.S.-based annuity experts are here to answer your questions about deferred annuities. If you need help working through your plans, call us at (866) 866-1999. We’ll give you honest answers to your annuity questions without any sales pitches. We’re here to help you.
Disclaimer: We are not tax advisors. This article is for informational purposes only and does not constitute tax advice. Please consult a certified tax professional regarding annuities and taxation.
References:
- “IRS reminds taxpayers their Social Security benefits may be taxable” Internal Revenue Service. February 9, 2022.
- “Form 1099-R Frequently Asked Questions” Lincoln Financial Group.
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Comments (1)
Markos S.
2024-02-28 22:51:33
Very informative report, especially for someone like myself who has an immediate problem: I am required by law to surrender the variable annuities that I have have with Fidelity for many years. I turned 90 and I am given the option to cash on, pay the tax to the federal government, state, and city, and then take the lump amount and do whatever I want. The other option is to receive a monthly sum for life. At 90 it is hard to know what option to choose.