A tax-deferred annuity provides tax deferral in which income tax on the yield on the original deposit of investment income is not charged during the investment period, as long as the funds remain on deposit in the annuity. The tax liability is postponed until the annuity’s owner or beneficiary begins to receive (or accesses funds) periodic payments of earnings from the invested funds. This benefit is known as “tax deferral.”
One of the most attractive features of a taxation annuity is a tax advantage known as tax deferral. Tax deferral is allowed as long as the funds in the annuity are kept intact and not touched by the annuity owner. The interest or earnings credited to the annuity grow and accumulate, tax-deferred, until the funds in the annuity, are accessed, either by the annuity’s owner or their designated beneficiary. The accumulated funds in the annuity can then be accessed as needed as a pension or supplemental income for the owner or beneficiary’s income needs.
The original deposit or deposits, the last funds to be removed from an annuity, are never taxed, as the tax liability is only assessed on the accumulated tax-deferred portion. Tools can assist the annuity owner in managing the future tax liability of a tax-deferred annuity, and be using these tools, and the annuity owner can shelter tax liability and use the future accumulated value as an income option. If the funds are merely removed, the full tax liability of the funds is due. Partial removal of the tax-deferred annuity results in appropriate tax liabilities on the amount withdrawn. However, when the annuity owner uses the funds in a tax-deferred annuity as income with a fixed payment option, the tax liability can be managed and spread over a time period chosen by the annuity’s owner.
This method of spreading the tax liability over a chosen time period is known as the “exclusion ratio,” or income option, and allows the annuity owner control over the tax liability. The actual amount of taxable income and tax-free income (the refund of original deposit) is calculated by the insurance company when the annuity owner initiates a fixed payment period option. The amount of actual tax liability varies, based on the amount of the original deposit, the accumulated earnings and the income option selected by the annuity owner.
In the event an annuity is inherited by a beneficiary, the full tax liability of the accumulated interest in a tax-sheltered or deferred annuity passes to the beneficiary. If the funds are removed in a lump sum, 100% of the tax liability is realized, but the IRS allows for a delay of up to five years in the beneficiary’s receipt of income from the annuity, which provides for tax planning fitting the beneficiary’s specific needs and situation.
