From an income tax perspective, annuities are tax-deferred products, so any growth in the subaccounts or interest credited to your account is not taxed until you take the money out.
Both “nonqualified” and “qualified” money can be invested in an annuity product. Qualified means money from traditional retirement accounts such as IRAs, Roth IRAs, 401(k)s, or similar. Nonqualified means simple after-tax money. There are different types of annuities, including fixed annuities, immediate annuities, variable annuities, and contracts that use an “index” to derive the gains or losses in the contract. Each type has its own set of pros, cons, and risks. Here is a general overview:
- Fixed annuities tend to be the easiest to understand. The owner receives a stated fixed rate of interest for a stated period of time, and there are not a lot of moving parts.
- Immediate annuities (sometimes referred to as single premium immediate annuities) are a contract where the owner gives the annuity company an amount of money, and in return the annuity company will pay that owner a fixed amount of money annually (either all at one time or monthly, quarterly, or semi-annually) for a stated period of time. Immediate annuities usually pay the owner for as long as the owner (or other designated recipient) lives.
- Variable annuities provide tax-deferred growth using subaccounts (similar to mutual funds) where the owner can customize the mix of stocks and bonds to match the contract owner’s needs.
- Index annuities provide potential interest credit to the value of the contract based on the results of the specific index the owner selects. This type of annuity probably has the most moving parts, as you need to understand “caps,” “spreads,” “point-to-point,” and other terminology as to how the contract works. These types of contracts generally offer an opportunity for more up-side potential than a traditional fixed annuity.
Please consider the investment objectives, risks, charges, and expenses carefully before investing. An annuity prospectus contains key pieces of information and details about the contract, and they can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Answer by: J. Victor Conrad, CPA (inactive), Pinnacle Financial Strategies LLC in Wexford, Pa.
PINNACLE Financial Strategies does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
Securities and advisory services offered through Commonwealth Financial Network member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered by PINNACLE Financial Strategies are separate and unrelated to Commonwealth.
***Answer originally published June 26, 2015.