Understanding Tax Deferral and Tax Implications
We know that understanding the benefit of tax deferral can be confusing for some people. We'd like to help you. When your investment is tax deferred you pay the tax on the interest and growth only when you receive it. This is unlike a CD where you are required to pay tax on the interest each year whether you leave it in the CD or not. The following chart helps to explain the concept.
| The Impact of Tax Deferral | ||
| Currently Taxed | Tax Deferred | |
| Current Balance | $100,000 | $100,000 |
| Interest Rate | 4% | 4% |
| Interest Earned | $4,000 | $4,000 |
| Tax Bracket | 28% | 28% |
| Tax Payable | $1,120 | $0 |
| After Tax Interest | $2,880 | $4,000 |
| After Tax Yield | 2.88% | 4% |
As you can see from the chart, you aren't earning the interest rate you're expecting when it is not tax-deferred. Compound that difference over a number of years, and you'll really start to see the impact.
| Growth of a Tax Deferred Annuity Over Time | ||
| # of Years | Taxable Investment at 6% | Tax Deferred Investment at 6% |
| 0 | $20,000 | $20,000 |
| 5 | $25,340 | $26,765 |
| 10 | $30,593 | $35,817 |
| 15 | $36,936 | $47,931 |
| 20 | $44,594 | $64,143 |
| 25 | $53,839 | $85,837 |
| 30 | $65,001 | $114,870 |
Many people when they begin taking payments from the annuity are no longer working and are in a lower tax bracket at that time which helps to reduce the overall tax effect.
Taxation of Annuity Payments
The tax treatment of payments made from an annuity will vary depending on when those payments are made. We at AM Warner Insurance Inc. advise you to consult with a tax professional to understand all the details involved. In general, the following rules apply.
Before Annuitization - Funds withdrawn prior to annuitization are considered to be made first from interest or other growth. (Withdraws from annuities entered into before August 14, 1982 were treated as first coming from principal.) These earning are taxable as ordinary income. If the annuity owner is under age 59 1/2 at the time withdraws are made, the earnings are subject to a 10% IRS penalty (except for death or disability of the policy owner). Any withdraw or payment of the principal of the owner's initial investment is treated as tax free.
After Annuitization - Regular annuity payments are treated as being composed of part earnings and part return of principal. The earnings portion (interest) is taxable as ordinary income while the return of principal portion is not taxable. The insurance company provides an annual statement to the annuitant detailing this information for their tax filing.
Estate Taxes - Any amount payable to a beneficiary under an annuity contract by reason of an owner's death is included in the owner's gross estate. Nothing is included in the estate if the life only payment option was selected.
